U.S. college endowments add inflation to worry list

A continuing "enrollment cliff" combined with rising interest rates and other worries are making risk a larger issue for college endowment officials, advisers say.

"We are not seeing trustees and leadership teams changing their approach to managing the endowment and their asset allocation, but believe they probably should," said Matt Bank, partner and deputy CIO at Global Endowment Management in Charlotte, N.C., an OCIO firm with $11 billion under management.

With many still recovering from pandemic-related challenges including drops in enrollment, "colleges across the country may be in for a difficult few years," Mr. Bank said. He advises them to reassess their risk appetite and consider making portfolio stability a priority, particularly as inflation becomes a bigger issue.

Inflation "is another conversation" we are having with endowment clients, along with enrollment decline, said Robert Appling, Denver-based managing director of Wilshire Advisors LLC, overseeing $39 billion in endowment assets. "I don't think any trustees or managers are naive in terms of trends," Mr. Appling said.

For colleges and their endowments, demographic trends are all too real. Birth rates that started dropping after the 2008 financial crisis could mean 15% fewer college entrants in the next college-age cohort.

Colleges forced to count on fewer students will have to make tough choices that include reducing spending or relying more heavily on their endowments, which may place pressure for higher return targets, as well as risk adjustments.

The pandemic didn't help. "The enrollment challenges existed before the pandemic, but it exacerbated it and brought it into stark focus," said Timothy Yates Jr., president and CEO of Commonfund OCIO, which manages $12.7 billion for endowments.

While some colleges had record levels of enrollment during the pandemic, others were forced to close their doors or be in defensive mode and seek more liquidity. And when inflation makes everything more expensive, "that results in a rethink of asset allocation, both in terms of risk and where you can get higher return," said Mr. Yates, who is seeing clients raise their return targets.

The downward trend in college enrollment was exacerbated in 2022 by market losses and pandemic-related pressures. This year, the slightly better news is that the rate of enrollment decline has slowed a bit.

Overall undergraduate numbers were down 0.2% last year, compared with -3.9% and -3.7% in the two previous years, according to the National Student Clearinghouse Research Center, the research arm of the educational non-profit National Student Clearinghouse.

Last year was also tough for endowments, which according to the National Association of College and University Business Officers, account for an average 11% of college revenues.

The 2022 NACUBO-TIAA Study of Endowments released in February found that of the 678 institutions covered, the largest endowments saw a 3.8% market value and the smallest had a 9.6% average decline in the fiscal year ended June 30, 2022.

It was "one of the most challenging periods for equity and fixed income assets in recent years," the study said, while the disparity between the largest and smallest endowments was due to varying allocations to private markets, particularly venture capital and private equity strategies.

Smaller endowments allocate more to public equities and public fixed income, but "both asset classes struggled in FY22 as interest rates increased," the study said.

Colleges are bracing for enrollment declines to accelerate again in 2025 and at least the next four years after that. "I don't think we are in any kind of red-flag situation with the universities we work with, but it's definitely top of mind," Wilshire's Mr. Appling said.

More immediate concerns for endowments are rising interest rates and whether there are opportunities to reduce risk, Mr. Appling said. "The equity risk premium is narrower than it has ever been," he said, and endowment offices are looking for opportunities to reduce risk by increasing allocations to fixed income and alternatives, including sector-specialist venture capital and buyout strategies pursuing trends in health care, technology and industrials spurred in part by the pandemic.

College investment committees need to think about inflation for two fundamental reasons, Commonfund's Mr. Yates said. It causes lower or even negative returns in inflation-sensitive asset classes such as bonds, and it erodes the institution's purchasing power, so understanding inflation is a critical exercise in setting investment and spending policies, he said.

The hunt for higher returns "triggers the asset allocation discussion for our clients, and the area where they are most likely to be compensated is illiquidity," which leads to increased asset policy levels for private assets, Mr. Yates said.

Increasingly for endowments, alternatives represent more than traditional private equity buyout funds or real estate funds. Some endowments are now considering more specialized funds or private credit, which takes "really skilled active management to put the endowment money to work," Mr. Appling said.

Even within existing alternative allocations to private equity, real estate and hedge funds, "there is a lot of new and interesting strategies" such as cold storage and industrial development, and more opportunities in private credit, Mr. Yates said.

The use of outsourced CIO providers, a trend that saw rapid growth a decade ago, is still seeing growth, said Kristin Reynolds, Boston-based partner of endowment and foundations at investment consulting firm NEPC LLC, with $110 billion in endowment and foundation assets. The pressure on advisers to deliver performance, or be replaced, has also grown, she said.

While her firm is seeing a shift in what colleges spend money on, their endowments are still cash positive and not changing asset allocations. There is more talk about downside risk, but not much change in endowment's risk profiles so far, Ms. Reynolds said.

A more immediate concern for endowment clients are private equity valuations, leading them to differentiate by vintage years and push for lower fees. "We have seen managers being more creative with their fees" to satisfy client demand, Ms. Reynolds said.

When it comes to responsible investing or environmental, social and governance considerations, "in the endowment space the news is still somewhat the same," with investors asking for proactive solutions rather than bold moves such as divestment or exclusion, Ms. Reynolds said, and more interest in addressing social issues like diversity, equity and inclusion than tackling climate change, which can be trickier to measure and target.

For now when it comes to ESG, "many endowments and foundations are having the conversation about what is possible, given the wide range in options from divestment to integration to impact," said Mr. Appling of Wilshire.

According to the latest NACUBO-TIAA study. Across a wide range of asset classes, 18% of colleges and universities include responsible investing criteria within their investment activities, while another 18% are considering it.

By asset class, more than 26% incorporate responsible investing criteria in their private equity allocations, up from 21% in the 2021 study, and the trends are similar for venture capital, private real estate, and private energy and infrastructure investments.

As a result of the increased focus on diversity, equity and inclusion, 24% plan to add or expand those approaches in their investment portfolio or investment policy, the study found.