Should you be worried about the Williams endowment? Consider The Economist:

Ivory-towering infernos

America’s universities have seen billions of dollars go up in smoke

HARVARD will have to take a “hard look at hiring, staffing levels and compensation”, wrote Drew Faust, the university president, on December 2nd in a surprise letter to Harvard deans. The Harvard endowment, which was worth $36.9 billion at the end of June, has since lost at least 22%, says Ms Faust. The university should brace itself for losses of 30% in the fiscal year to next June, she adds, although even that may prove far too optimistic. Its ambitious plans for new buildings on the other side of the Charles river seem likely to be scaled back, or at least slowed down.

Harvard is not alone. At Stanford University, the president, provost and other senior executives have taken a 10% pay cut. There is speculation that its endowment, which at $17 billion in June was third only to Harvard’s and Yale’s, has performed horribly since then. Many smaller endowments—only six were bigger than the $8 billion that Harvard says it has lost so far—have suffered too. Williams College has seen its endowment plunge by 27%, from $1.8 billion to $1.3 billion, while Wesleyan University’s has tumbled by 24% to $580m.

I have never seen a 27% number from Williams or even an official estimate of $1.3 billion. Will Stack ‘11 reported the $1.3 billion number, as did the Record.

It is projected that the College endowment has dropped precipitously since June 30 because of its 48 percent exposure to equity markets, which have been in sharp decline. Although no exact figure has been calculated as to its current value, President Schapiro estimated that the endowment is probably worth around $1.3 billion today, a $500 million, or about a 28 percent drop since the last time it was precisely calculated on June 30.

“If we have $1.4 [billion] now I’d be shocked; it’s probably $1.3 [billion],” Schapiro said, noting that part of this decrease is due to the College’s withdrawals of 80 or 90 million dollars a year, about 5 percent of the endowment, for operational expenses.

Keep track of two different types of decreases in the endowment: falls in the value of investments and withdrawals for spending. The Economist is only discussing the former and yet is using the $1.3 billion number that includes both categories. Comparing Harvard’s 22% fall (all because of investment losses) with Williams’s 27% fall (both losses and spending) is apples and oranges, or perhaps crabs and clementines.

The real uncertainty is in the portion of the endowment that is not in publicly traded securities. Williams (and other schools) don’t know what is going on with these investments. In fact, even the professional managers in charge don’t really know! Assume that you are running a venture capital firm and have used $500 million to buy a company last year. Williams (along with 9 other endowments) invested $50 million. How much is that investment worth now?

No one knows! Rant continues below.

Now, if the company you bought is “similar” to another publicly traded company which is down 40% in price, you might estimate that the value of the company you bought is down the same. So, the $50 million that Williams invested is down to $30 million. But can you be certain? No! Even “similar” companies are different in many ways and you have been working to improve the company you bought for the last year. So, maybe you think that the company’s value has only dropped by 10%.

Readers unfamiliar with the investment world should remember that every endowment is, ultimately, a collection of pieces of paper. Williams owns shares in IBM or it has invested in a hedge fund (which then bought some IBM) or it has invested in a real estate partnership which controls various properties. Whatever the investment vehicle, at the bottom there is a piece of paper which gives Williams certain rights.

To know how Williams is doing, we need to value those pieces of paper. In the case of IBM (and other publicly traded pieces of paper), that’s easy. Their prices are listed in the newspaper everyday. But for everything else, it is tough to know what is going on. How much is an investment in private company X or building Y or timber forest Z worth? Short answer: Whatever the manager (and his auditors) report that they are worth. Potential for abuse? You betcha!

So, when Morty (or Collette Chilton) reports that the endowment is at $1.3 billion (or whatever), this is, at best, an educated guess. None (?) of the College’s investments in non-publicly traded pieces of paper report more than quarterly, and even the quarterly reports are not taken as seriously as the annual. And even the annual report is subject to influence by the investment manager.

Indeed, the main case against private equity and venture capital is that these investments provide little more than levered exposure to equities (plus smoothed reporting). Imagine a private equity firm that took $50 million from Williams in 1998. It then borrowed another $50 million. Then it invested in randomly chosen companies which performed no better or worse than the S&P 500 over the decade to June 30, 2007. That fund would have done almost twice as well as the S&P 500 (since it invested $100 million in such companies (and ignoring the cost of debt)). And, even better, the managers are allowed to smooth reporting so that the results seem way less volatile than the S&P (even thought they are actually twice as volatile). The managers can smooth by reporting only a 20% gain in 1999 even though the actual gain was 80% and then a 10% loss in 2000 even though the actual loss is 70%. No one can check this because the companies invested in are not publicly traded. So, the accountants (who are hired by the managers!) are likely to allow them a fair amount of discretion.

Is this a big concern for the Williams endowment? Probably not. We invest in the best managers and the endowment has done well. (See this academic paper for more detail.) I go through all this background because I want to prepare people for the possibility that the endowment might be much worse off than any of us expect right now.

Do I think that it is? No. But I won’t be surprised if it is, if it is a fantasyto believe that the endowment is worth $1.3 billion, that we are in much more trouble than anyone at the College suspects.

Evidence? Harvard is freezing all faculty and non-union staff salaries. Stanford is cutting top administrator salaries by 10%. If the Williams endowment is invested similarly to these elite schools (and it is) and Williams is poorer on a per-student basis (and we are), then why isn’t Williams acting as aggressively to bring its costs in line? What do Harvard and Stanford know that we do not?

Harvard is trying to sell some of its private equity investments at 50 cents on the dollar, and failing! Williams is either invested in those same funds or in funds just like those. Is Morty valuing those investments as down 50%? No. The managers haven’t reported those losses yet, and they don’t have to report them for years. If the market/economy bounces back, maybe there won’t even be any losses. (And maybe those South Beach condos I bought in 2007 will work out eventually.)

Again, I am not worried yet. I walked out of the Boston Alumni Meeting half as worried as I walked in. Seeing Morty talk about the cost-cutting already underway, listening to chair of the executive board of the trustees Greg Avis ‘80 discuss the College’s priorities, knowing that Provost Bill Lenhart was keeping a watchful on the planning process for several years in the future — all those signals and more were reassuring.

But, still. Harvard and Stanford have accomplished presidents, financially knowledgeable trustees, and competent provosts. If their endowments are down so much, then shouldn’t Williams be in trouble too? If they are cutting costs very seriously, shouldn’t we be too?

At the very least, responsible trustees would be demanding that Collete Chilton adhere to the best practices of endowment reporting. I would sleep better if I knew that Williams were not, say, invested with Bernie Madoff. Wouldn’t you?

Back to The Economist:

The model may also have been adopted by endowments that were too small for it. “You need to be very big and very diversified, and to be sophisticated enough to understand the risk management of complex investments,” says Anthony Knerr, who advises universities on funding strategies. Some of the hardest hit may be smaller endowments that adopted a “Yale-lite” strategy that they did not really understand. They may also have been unable to invest in the best hedge funds and private-equity firms, which have (until now) been able to pick and choose between investors.

Consultant argues that you need to hire consultants. Surprising!

A $1.3 billion dollar value for the endowment is not an unreasonable estimate. Subtracting out the College’s $260 million in debt and applying the 5% avail rate, Williams should plan on spending no more than $50 million from the endowment on operating expenses in 2009-2010. Have we made enough cuts to accomplish that? Nowhere close.

Summary: There is a large (5%? 20%) chance that the endowment is worth much less than $1.3 billion, that the College’s illiquid investments in private equity, venture capital and real estate should be valued at 50 cents on the dollar. Without better transparency, it is hard for us to know the facts, or even come up with better estimates.

Do not be surprised if the College’s reported value for the endowment is well below $1.3 billion come June 30, 2009, even if the financial markets are largely flat between now and then.