Moody’s Investors Service recently released a report bluntly entitled, “Private equity exposure increases credit risk for universities with limited wealth.” This is not an opinion by a columnist like me; it will be read as an order in all but name from an organization that influences credit access and interest rates paid by smaller universities. It might as well have been titled, “If you’re not Harvard or Yale, you had better get your endowment out of private equity or worry about your ratings.”
The report isn’t subtle. On page 3 is a chart with names redacted of 59 universities with smaller endowments that Moody’s rates. Board members of all those universities can easily find their school based on its numbers and see where it ranks on the naughty list.
Of course, part of Moody’s responsibility is to inform creditors and lenders about factors that influence its ratings. And there are plenty of risks associated with putting 30% of an endowment in private equity. It’s just that credit isn’t one of those risks.
The report begins with noting that private equity is less liquid than public equity, which no one denies. No explanation is given about how that relates to credit risk. One major credit risk is a liquidity crisis — not having the cash you need to pay wages or service debt. If a school is counting on endowment income to pay its bills and that income doesn’t materialize, it could find itself in default.
But no one counts on private equity investments for income cash flow. Typical investments pay nothing or even consume capital for 10 years or so, and then pay capital gains on an unpredictable schedule. You can’t be disappointed by the cash flows of an investment from which you didn’t expect cash.
If a school put its endowment in high-yield bonds and earmarked the income to pay bills, then it could face credit problems if some of the bonds defaulted. If the school planned to sell public equities for income, and the stock market tanked, it might be in trouble. But private equity cannot cause short- or medium-term cash flow problems.
It is true that in an emergency it’s easier to sell investments in public equity than in private equity. But holding 30% of the endowment portfolio in private equity would only matter if the school needed to sell more than 70% of that portfolio to pay short-term bills. In that case, the university is unlikely to survive whatever it does. Keeping all your assets in cash against the worst imaginable scenario is not prudent risk management. You’ll have cash, but you probably won’t earn the return you need over inflation to attain long-term viability.
The report goes on to cite the usual litany of private equity negatives — high and complex fees, the uncertain expected return advantage over public equities, conflicts of interest, risk disguised by stale pricing, valuation disputes, and the need for more investor expertise and due diligence than with conventional public investments.
Any prudent investor will consider these and weigh them against the hope for superior returns from businesses freed from the costs and short-term focus of public investments, overseen by managers laser-focused on shareholder value as opposed to boards of directors at public companies who often seem too indulgent of management and distracted by multiple agendas. Here too, there is no connection with credit risk.
If an institution is solvent, that is it can pay its bills for the moment, the next major credit risk is that it lacks long-term viability. Declining enrollment, for example, or the inability to attract qualified faculty and staff or being cut off from government support might make a university a poor long-term credit risk, even if it’s swimming in cash today.
Endowment losses could contribute to a negative spiral. Donors might be reluctant to give funds to a university that loses the money. Students might think twice about enrolling in a university that might fail or be unable to maintain quality. Similarly, faculty, granting institutions and companies might decline to consider the school. Part of that spiral might be negative actions by credit rating companies like Moody’s.
So, Moody’s has reason to warn of excessive volatility in endowment portfolios. But this report offers no evidence that schools with larger private equity allocations have greater endowment volatility.
A recent paper in the Journal of Alternative Investments, “Demystifying Illiquid Assets: Expected Returns for Private Equity,” compared private equity returns with levered investments in a small cap public stock fund. Based on its conclusions, an endowment that replaced 30% of diversified public equity investments with 30% private equity would likely increase overall portfolio volatility. But if a 30% investment in private equity was combined with 10% in fixed-income or real estate to replace 40% in public equities, it might well represent the same or lower portfolio volatility. In any event, there’s no way to evaluate overall endowment volatility by looking only at the portion allocated to private equity.
More importantly, risk must be weighed against reward. A university can fail by excessive endowment risk, but can also lose out from long-term, substandard endowment performance. The Moody’s report looks favorably on universities holding large amounts of cash, but in the long run, cash almost always loses out to riskier investments.
It’s entirely possible that university endowments have allocated too much to private equity. This may in part be due to its return-smoothing properties that disguise risk, and perhaps with insufficient consideration to illiquidity and other issues. But the Moody’s report does not make that case and, if it did, it wouldn’t be related to credit risk.
I can’t think of any good reason for Moody’s to write a report claiming that private equity investments increase credit risk for some universities – which I read to mean that it’s a factor that could threaten their credit ratings — without backing up that claim. Merely rehashing well-known general investment concerns with private equity — and not mentioning credit — isn’t enough. If Moody really believes endowment allocations to private equity imperil non-wealthy university credit ratings, it should provide a more comprehensive and pointed explanation.
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