A Ticking Time Bomb?

Quietly amid the hue and cry over the latest student loan corruption scandal, the Senate Finance Committee is scrutinizing a much more esoteric topic in higher education finance: college investments in hedge funds.

It’s an issue that for years has been buried — the educational equivalent of a roadside IED (improvised explosive device). But if it should detonate, colleges and their students will suffer in some cases badly. Lightly regulated and notoriously secretive, hedge fund investments have become, over the last decade or so, de rigueur among college and university endowment managers. Leading the trend are elite institutions that have made billions on their hedge fund investments.

As the Senators have learned, universities like Harvard, Yale, and Stanford have set up off-shore “blocker companies” in exotic locales such as the Cayman Islands, where the tax laws tend to be more lax. These universities then funnel endowment funds into their “blocker companies,” which in turn invest the money in hedge funds.

The result? Institutions are able to convert profits generated by debt-financed investments (hedge-fund revenue that is subject to taxation) into dividends, which are not. Perhaps hundreds of not-for-profit institutions engage in the practice, which at the moment is legal. Senators eager for new revenue sources to pay for their priorities — including expanding tuition tax breaks for students — are considering taxing profits from debt-financed investments. But first, the lawmakers say, they are trying to get a better handle on hedge fund operations — who has them, how big they are, and how they invest.

“I want the facts,” Sen. Max Baucus (D-MT), chairman of the Senate Finance Committee, told Bloomberg.com. “I want to know whats going on here.”

Therein lies the rub. Hedge funds jealously guard their secrets, whether they use derivatives, buyouts, computer trading, arbitrage or short selling, to name a few strategies employed by the funds. It is all but impossible for meaningful data to escape the black hole of a funds gravitational field.

Because so much money is at stake, institutions that invest in hedge funds are sworn to secrecy, on penalty of being ostracized. Such a fate befell the University of California three years ago when Sequoia Capital, a hedge fund that had invested in Google prior to its IPO (a windfall for Cal) notified the university that it would accept no new investments. The impetus for severing the 22-year-old business relationship was a California court ruling that required public institutions to divulge information about their hedge fund investments.

PUTTING STUDENTS AT RISK?

Asked by the Senators about their use of “blocker companies,” the big three universities were, shall we say, circumspect. “Harvard does not discuss investment structuring Stanford probably uses intermediary companies in some cases Yale couldnt immediately comment,” university spokesmen told Bloomberg.com.

So whats the big deal? Colleges and universities have invested billions of dollars in unregulated, secretive funds and reaped billions in capital gains. Yale, which has set the gold standard for higher education investment success, puts about a quarter of its endowment in hedge funds. Another significant chunk of its nest egg is invested in other so-called alternative investments, that is, something other than the pedestrian stocks and bonds available to, say, owners of 529 college savings plans.

Given the performance of Yale and other large endowments, it is no surprise that the trend toward investing in hedge funds has trickled down to smaller institutions. Yet with fewer resources at their disposal for vetting hedge funds and less access to the best fund managers, smaller endowments are more vulnerable to the risks of hedge fund investments.

And what if the hedge funds that these colleges invest in collapse? For colleges, which are heavily reliant on income generated by their endowments’ investments, such an outcome would lead to a financial crisis. One can easily envision institutions hiking tuition — the only revenue stream over which they have direct control — and slashing their investment in need-based student financial aid to offset losses suffered in a hedge fund meltdown. In the worst case scenario, a financially struggling college could be pushed into insolvency, leaving heavily indebted students in the lurch.

Farfetched? Not according to many financial analysts, who say the odds of catastrophic hedge fund failures are rising. In May, Reuters reported that “hedge funds may now pose the biggest risk of a crisis since 1998.”

In 1998, Long Term Capital Management, one of the top hedge funds at the time, collapsed, necessitating a multi-billion-dollar bailout by the Federal Reserve Bank of New York. Last September, a $6 billion loss sank Amaranth Advisors — the largest such hedge fund casualty to date. It is unknown how big a hit, if any, college and universities took.

College and universities must consider their compact with the public. The tax exempt status of these institutions is contingent on their promoting the public good, which they will be far less capable of should their investments in hedge funds bottom out. Endowment managers at Harvard, Yale and elsewhere say they have formulas for minimizing their risk. Dont bother asking for an explanation, though. They won’t tell.

And to Higher Ed Watch’s mind, this wont do. Hedge funds were designed for super wealthy investors who can take big risks and weather big losses without the safety net afforded by governmental regulation. A handful of institutions of higher education with multi-billion-dollar endowments may well qualify.

Many more institutions of higher education, however, exist on a delicate financial bubble. The proposal to tax endowment income from hedge funds, if enacted, could force endowment managers into a more careful consideration of their asset allocation. But perhaps a much more fundamental question should be asked: Should colleges be making such risky investments in the first place?