When Leaks Turn into Floods:
Challenges Facing Higher Education

January 19, 2018  | by Timothy T. Yates, Jr.

Governance and Policy | Industry Knowledge | Investment Strategy | Operating Assets | Outsourced Investing | Risk Management

2017’s tax legislation is the latest in a growing list of challenges facing higher education. The new excise taxes on endowment earnings of the largest private universities, coupled with the not-yet-fully-understood impact of the increase in the standard deduction on overall charitable giving, may not by themselves break the proverbial bank. However, when considered in the context of broader trends, we believe fiduciaries should be vigilant that leaks don’t turn into a flood. The best way to do this is to have sound policies that govern decision making and that are formulated, and evaluated, in a cross-functional fashion across the institution. Risk identification and management that includes stress testing on an enterprise-wide basis should also be part of the protection plan.

A hypothetical small private college can illustrate how these leaks could turn into a flood. With an endowment of $100 million, an operating budget of $100 million, and 2,000 undergraduates, Fictional College would not be impacted by the excise tax on endowment earnings as that tax applies to only those private institutions with endowment-per-student ratios of $500,000 or more. However, only 5 percent of Fictional College’s operating budget is supported by the endowment so net tuition revenue is a more critical factor for the school. On a national scale, enrollment peaked earlier this decade and declined on a rolling 4-year basis for the first time in a generation in 2015.

img_floods_chart1_enrollment_trends_in_higher_education

Indeed, according to NACUBO, more than half of respondents saw declines in total undergraduates or first-time freshmen and 39 percent experienced declines in both their first-time freshmen and total enrollments.1 As a result, the environment has become more competitive and many have responded with higher discount rates, which reached an estimated 49.1 percent in 2016-2017, the highest level recorded in the history of the Tuition Discounting Study project (first-time, full-time freshman).

img_floods_chart2_avg_institutional_tuition_discount

Rising discount rates have led to much slower growth in net tuition revenue, or, for many colleges, declines in net tuition revenue. At the same time public funding has declined. In 2014-15, appropriations per full-time equivalent student were 8 percent lower in inflation-adjusted dollars than they were a decade earlier and 11 percent lower than they were 30 years earlier.2

Gifts may help the situation, but there are estimates that giving could decline up to 5 percent due to the new tax law’s higher standard deduction. Fictional College probably gets 2-5 percent of its total revenues from giving, so this may be another leak. Even before the tax legislation, charitable contributions to colleges and universities in the United States increased only 1.7 percent in 20163, a gain that was nearly eliminated when adjusting for inflation. Moreover, giving has been increasingly concentrated at the larger, more well-known institutions, with just 20 institutions (less than 1 percent), receiving 27 percent of all gifts in 2016.4

The realities of lower net tuition revenue, declining public support and lower contribution rates are happening at a time when the costs of running a higher education institution or providing a scholarship (the cost of tuition) continue to rise. The Higher Education Price Index (HEPI), which tracks a fixed market basket of goods and services purchased by colleges and universities, increased 3.7 percent in FY 2017 – the largest increase since 2008 – and the increases in tuition have been well documented.

Returning to Fictional College, we can envision a stress scenario where the leaks become a flood. If costs rose 3.7 percent, net tuition revenue declined 2 percent, endowment income remained flat, gifts dropped 5 percent and other revenue dropped 4 percent, we would see a potential deficit of almost $6 million.

img_floods_chart3_deficit_table

Preparing for this scenario requires an integrated approach to understanding operating and financial metrics across the institution. How much flexibility is there, what is the debt capacity, what is the liquidity profile, and how are unrestricted assets treated? These are the types of questions that should be asked at the board level and across investment/finance committees, finance offices, development teams and others. From these questions, sound policies can be established, revisited or refined. And, lastly, a response plan for the next crisis, or a “crisis playbook,” is undoubtedly easier to put in place when the waters are calm and market volatility is low.

1 Source: 2016 NACUBO Tuition Discounting Study (TDS)

2 Source: Center on Budget and Policy Priorities. “Funding Up, Tuition Down”, August 15, 2016.

3 According to the Voluntary Support of Education (VSE) survey, conducted annually by the Council for Aid to Education (CAE).

4 Council for Aid to Education.

Authors

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Timothy T. Yates, Jr. is a Managing Director and responsible for custom solutions for clients across public and private markets. In this role, he leads a team of investment professionals that advise, implement and monitor custom investment solutions. He is also a senior member of the firm’s private emerging markets portfolio leadership team with a particular focus on Latin America. Tim joined Commonfund as an associate in the Commonfund Capital Associate Program. He later joined the Strategic Solutions Group, Commonfund’s OCIO platform, where he was responsible for the design, tailoring and implementation of total portfolio solutions. Before joining Commonfund, Tim was an instructor of Spanish and Italian at Fordham Preparatory School. He holds an M.B.A. in Finance with a designation in International Business from Fordham University and a B.A. in Modern Languages from Trinity College. Tim is also a member of the investment committee for St. Paul’s Church in Fairfield.
Timothy T. Yates, Jr.
Managing Director
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Disclaimer

Information, opinions, or commentary concerning the financial markets, economic conditions, or other topical subject matter are prepared, written, or created prior to printing and do not reflect current, up-to-date, market or economic conditions. Commonfund disclaims any responsibility to update such information, opinions, or commentary. To the extent views presented forecast market activity, they may be based on many factors in addition to those explicitly stated in this material. Forecasts of experts inevitably differ. Views attributed to third parties are presented to demonstrate the existence of points of view, not as a basis for recommendations or as investment advice. Managers who may or may not subscribe to the views expressed in this material make investment decisions for funds maintained by Commonfund or its affiliates. The views presented in this material may not be relied upon as an indication of trading intent on behalf of any Commonfund fund, or of any Commonfund manager. Market and investment views of third parties presented in this material do not necessarily reflect the views of Commonfund and Commonfund disclaims any responsibility to present its views on the subjects covered in statements by third parties. Statements concerning Commonfund’s views of possible future outcomes in any investment asset class or market, or of possible future economic developments, are not intended, and should not be construed, as forecasts or predictions of the future investment performance of any Commonfund fund. Such statements are also not intended as recommendations by any Commonfund entity or employee to the recipient of the presentation. It is Commonfund’s policy that investment recommendations to its clients must be based on the investment objectives and risk tolerances of each individual client. All market outlook and similar statements are based upon information reasonably available as of the date of this presentation (unless an earlier date is stated with regard to particular information), and reasonably believed to be accurate by Commonfund. Commonfund disclaims any responsibility to provide the recipient of this presentation with updated or corrected information. Past performance is not indicative of future results. For more information please refer to Important Disclosures.