Flapping his arms, David Swensen pulls a pop-eyed, mock-outraged face. He's mimicking his critics-second-guessers, in his view, who praised him before the economy caved but now accuse him of leading the nation's endowments astray. "What a stupid idea that was!" Yale's chief investment officer yells, role-playing.
Swensen's idea, implemented at Yale and copied nationwide, was that universities should shift their endowment money out of traditional investments such as stocks and bonds and into higher-yielding ones like private equity, hedge funds, and real estate. The Yale model, as it came to be known, perennially outperformed stodgier strategies, gaining Swensen gurulike adulation. Since June, though, endowments on average have given up 22.5 percent of their value. Moreover, the economic crisis would seem to have exposed a major flaw in the Yale model: Alternative investments like private equity and real estate are very difficult to convert to cash without significant loss, leaving universities with a dearth of ready money. As a result, many schools have slashed operating budgets and sold off stocks at depressed values. Swensen is unrepentant. Walking me through his offices on the fifth floor of a brick building a couple of blocks from campus, he shows me a slip of paper documenting the Yale endowment's performance in the decade ending June 30, 2008: up 16.3 percent annually, compared with 6.5 percent for the average college endowment and 2.9 percent for Standard & Poor's 500-stock index. The value added to Yale's coffers was $14.9 billion.
Since Swensen took over in 1985, Yale's endowment has led all universities in average returns and leapfrogged Princeton and the University of Texas to become the second largest, behind Harvard. In the spring of 2008, alumni mounted a campaign to name a new residential college after him. His insights into the markets landed him a spot on President Barack Obama's economic-recovery advisory board.
Tributes clutter the walls and shelves of Swensen's office: a 2006 fan letter from Warren Buffett ("Yale and the investment world owe you a great deal"); the Mory's Cup for distinguished service to Yale, an award whose other recipients include former president George H.W. Bush ("Bush one, not Bush two," Swensen notes); and a limerick in his honor by the economist and Nobel laureate James Tobin, celebrating the endowment's reaching $10 billion in 2000. Called "Son of Sven," it neatly summarizes the biography of Swensen, a Wisconsin native with a doctorate in economics from Yale: "A young Viking, a badger called Dave?/?Determined poor Eli to save?/?First he'd be?/?A PhD?/?And then make those markets behave." Mugs illustrated by the children's book author Sandra Boynton commemorate several endowment milestones: "I actually drink out of the $6 billion coffee mug every morning," Swensen says.
He earned these plaudits with a bold strategy that increased Yale's stake in private equity from 3.2 to 20.2 percent; in real assets-timber, real estate, and the like-from 8.5 to 29.3 percent; and in hedge funds, from zero to 25.1 percent. During his tenure, the share of Yale's endowment invested in domestic stocks and bonds has dropped from 71.9 to 14.1 percent.
In his 2000 book, Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment, and in numerous speeches, Swensen championed such alternative investments. He argued that while beating the stock market is almost impossible because so much information is available about public companies and shares are accurately priced, shrewd managers can exploit inefficiencies in the pricing of less familiar private assets. Diversification into alternatives, he added, reduces risk.
He contended that keeping funds in investments that are more liquid-that is, easily converted into cash-is more valuable to short-term players than to endowments, which can afford to wait until private assets are sold or go public. He brushed aside concerns that most alternative investments are tied up for years and therefore illiquid. "Investors should pursue success, not liquidity," he wrote. "Portfolio managers should fear failure, not illiquidity." And again: "Accepting illiquidity pays outsize dividends to the patient long-term investor."
For endowment managers, the Yale model appeared to solve a constant dilemma: how to generate returns high enough to support their operating budgets and simultaneously preserve capital for the future by allowing growth to keep up with inflation. Princeton, the Massachusetts Institute of Technology, and Bowdoin College hired Swensen prot�g�s to run their endowments. By the 2007 fiscal year, colleges were devoting 42 percent of their endowments to alternative investments, up from 23 percent in fiscal 2000, according to Commonfund, a money manager for nonprofit institutions. Endowments grew so fast that many schools, including Yale, hiked their payouts-the percentage allocated to the operating budget. Private equity was particularly rewarding, averaging a 16.9 percent annual return to university endowments.
Now, the recession that has already undone the reputations of Alan Greenspan, Robert Rubin, and other economic sages threatens Swensen's too. Nearly every sort of alternative investment has been slammed, undermining Swensen's diversification rationale, and his advice to downplay liquidity has backfired. With private donations dwindling and students clamoring for aid, universities that followed the Yale model find themselves in a plight that could be called cash-22. The publicly traded stocks they still own have plummeted in value, leaving the schools overdependent on illiquid alternatives-and constrained by contractual obligations to invest even more.
The Yale model assumes returns when private holdings go public, but no initial public offerings are taking place.From the best and brightest on down, most universities failed to anticipate this quandary. Harvard, Duke, Columbia, and the University of Virginia are looking to unload private equity at a loss by trading it on a secondary market that has emerged as a last resort during the cash crunch.
Many schools are also trying to redeem shares in hedge funds-generally considered the most liquid alternative investment-only to encounter "gates" or "lockup clauses" in their contracts that prevent them from getting their money back. Brandeis University, which boosted its allocation to alternative investments from 29 percent of its endowment in 2003 to 65 percent in 2008, has seen its endowment drop 23 percent since June, and several of its big donors have been hit by losses in the Bernie Madoff fraud.
To raise cash, Brandeis has considered closing its art museum and selling its renowned collection of contemporary art. Other schools are imposing salary and hiring freezes and delaying building projects. Like many investors who bet on mortgage-backed derivatives and similarly novel strategies during the boom, the Yale model's adherents have painfully learned the old lesson that greater returns carry greater risk.