Investment Strategy Carries Risk, Capital Commitment
Published in print on October 31, 2010
By Rick Jurgens, Special to the Valley News
University endowments once consisted largely of a straightforward mix of stocks, bonds and cash of the kind that makes up a typical individual investment account. But in recent years, Dartmouth and other elite institutions have increasingly turned to "alternative" investment vehicles -- hedge, venture capital, private equity or buyout funds -- which promise high returns, but can carry high risks and lock money in investments that cannot be sold quickly.
Such investments helped Dartmouth's endowment grow from $2.5 billion in 2004 to nearly $3.8 billion in 2007. But when the market turned sour in fiscal 2008-09, at least some of the $835 million drop in the college's endowment value could be traced back to alternative funds.
Many people remain mystified by what hedge funds are or do. Among those professing ignorance -- at least until earlier this year -- was Dartmouth President Jim Yong Kim. "I had no idea what a hedge fund was" until investment committee chairman William Helman IV provided a two-day tutorial, Kim told The Wall Street Journal in March.
Still, some hedge fund managers have become household names, including George Soros, the Hungarian immigrant who made a billion dollars betting against the British pound; John Paulson, the Wall Street partygoer who pocketed $14 billion by betting that house prices would fall; and, more darkly, 1997 Nobel Prize-winning economists Myron Scholes and Robert C. Merton, whose superstar resumes lured investors to Long Term Capital Management, the hedge fund that collapsed in 1998 and nearly brought down Wall Street.
While alternative funds share key characteristics with the mutual funds familiar to millions of Americans through their retirement accounts, there are some important differences.
The funds operate on the unregulated side of a line drawn by the Investment Company Act of 1940, which mandates "adequate independent scrutiny" of fund finances and management but exempts funds that are open only to investors presumed to be sophisticated enough to look out for themselves.
The biggest distinction comes on payday.
Mutual fund managers collect annual fees equal to a small percentage of the assets their funds hold, usually in the neighborhood of 1 percent. Alternative funds typically collect management fees of between 1 and 3 percent plus -- and this is a giant plus -- anywhere from 10 to 30 percent of whatever gains they make with their investors' money.
Dartmouth began putting some of its endowment into alternative investments as far back as the late 1980s. It posted dramatic gains in recent years, when the investments were overseen by a small group of alumni who were major donors, leading fundraisers, members of key governing boards at the college -- and managers of private funds that profited by managing some of those same investments.
Dartmouth has by no means been the only institution with a multibillion-dollar endowment and a growing appetite for risk.
Over the past 25 years, Yale University became a pioneer in alternative investing, and other schools with large endowments followed. College endowments valued at more than $1 billion had 61 percent of their assets tied up in such "alternative investments" in the 2008-09 fiscal year, according to a study by the National Association of College and University Business Officers and the Commonfund Institute.
At Dartmouth, such alternative investments grew to account for 67.5 percent of the value of the college's endowment, according to the 2009 Endowment Report posted on the college's website.
That growing stake upset some in the Dartmouth community. Joe LaVigna, a retired investment banker who graduated from Dartmouth in 1959, said he believes the college should never tie up more than 30 percent of its endowment in alternative assets.
"I was aghast at how much risk was taken on," he said in an interview, as well as by the lack of liquidity.
Liquidity -- which refers to the ability to convert an asset into cash quickly, easily and without incurring a large loss -- is limited by the investment contracts of hedge, buyout and venture capital firms. Such contracts often obligate investors to limit withdrawals or make new investments at the discretion of the managers.
The college still has a substantial commitment to make future investments. By the end of 2009, Dartmouth estimated its maximum future commitments to invest in private investment partnerships at less than $600 million, or less than 20 percent of its $3 billion endowment, according to nonpublic information reviewed by the Valley News.
It's virtually impossible that all those commitments would kick in at the same time, experts say. However, the commitments do represent potential future liabilities for the college, and they are also included in the calculation to determine management fees on some contracts, according to information reviewed by the Valley News.