Questions on Michigan's Investment Tactics

Recent scrutiny of investment practices by the University of Michigan is raising concerns about conflicts of interest and ethical lapses at colleges and universities seeking to increase their endowments.

Questions about Michigan’s investment practices were prompted by an investigation by the Detroit Free Press, which found that a large portion of the university’s nearly $11 billion endowment is invested in private equity, hedge and venture capital funds, and real estate investment firms run by top university donors and alumni investment advisers.

The newspaper chronicled how the university received hundreds of millions of dollars in donations from executives at top investment firms and then invested in funds managed by those same firms.

Among other things, the newspaper highlighted how Michigan invested its funds. More than $400 million went into funds managed by alumni who advise the university on its investments, according to a series of articles by the Free Press, which scrutinized the relationship between Michigan's investments and its donors. The university also invested in companies “owned or co-led” by at least four members of a nine-member committee focused on helping the university increase its endowment, the newspaper reported.

“On top of working capital, their companies, based on industry practice, likely charged millions of fees and profit-sharing as the price for managing the university’s money; exact figures remain secret,” the Free Press reported.

Michigan administrators have pushed back against the Free Press reports and defended the university’s investment practices, which they insisted involved no favoritism to donors or payback for their donations. They also issued a detailed written statement responding to various assertions in the Free Press articles. (The statement also includes written responses the university provided to numerous questions posed by the Free Press reporters.)

"Over the years, the university’s investment portfolio is distributed among hundreds of different investment companies representing a strategically balanced approach to investing designed to maximize returns on those investments," part of the statement reads. "The current value of investments the university has in funds being managed by members of the university’s Investment Advisory Committee represent 2 percent of the university’s total investment portfolio. That means 98 percent of the university’s investments are managed elsewhere; by fund managers who are not, in any way, advising the university regarding investment approaches.

"The fact is, U-M alums are some of the top investment managers in the nation. We would be foolish not to reach out to these alumni for their high-level advice and, when it fits with the university’s investment approach, to invest in their well-managed funds. The key fact is that all investment opportunities get vetted in the same fashion and we only invest with funds and managers that meet our stringent criteria."

Additionally, Rick Fitzgerald, the university's assistant vice president for public affairs, said in an interview that the members of the advisory committee do not have direct influence on Michigan's investment decisions. "They're only an advisory committee," he said. "They meet twice a year and advise the university on strategic investment. The give advice; they don’t make any decisions for the university and don’t decide on individual investments."

The Free Press also reported on the unusual pay structure of Michigan's chief investment officer -- 5 percent of his incentive pay is based on the endowment’s performance over three years.

"His bonus is also tied to his individual performance evaluation and how well Michigan performed compared with similarly sized schools," the newspaper reported.

According to Institutional Investor, the similarly sized institutions include about 100 other colleges or universities.

"This is controversial, one fund’s performance doesn’t affect another’s, and organizations can have vastly different needs and risk tolerances," the article states.

Fitzgerald, the university spokesman, said the incentive pay was not at all unusual.

"It's a pretty common practice in investment offices," he said. "He has a base salary and an opportunity to earn additional compensation based on the performance of investments."

Institutional investment and wealth management experts say Michigan is not alone in engaging in investment practices that have potential conflicts of interest, or at least the appearance of conflicts of interest. The experts say other colleges and universities have similar practices and are also risking their investments and their reputations.

“Some of the practices at the University of Michigan especially were not appropriate and not consistent with corporate governance best practices,” said Timothy Keating, an expert on endowment performance and head of the investment firm Keating Wealth Management LLC.

Keating was one of several people interviewed who found Michigan’s investment practices troubling.

“Unfortunately there are many such practices at endowments and the sins come in various shapes and sizes,” he said, adding that the increased media attention would bring more public awareness about the questionable practice. “I think they are going to be smoked out one by one.”

Michigan’s endowment is the ninth largest overall nationally and the third largest public endowment behind those of the University of Texas and Texas A&M systems, according to the National Association of College and University Business Officers.

The Free Press investigation also found that the advisory committee members tasked with helping Michigan increase its endowment steered donors to a special university fund, the Chief Investment Officer Endowment, established to help “defray the costs” of paying the sizable salary of the chief investment officer -- the same person who determines where Michigan invests its money. The committee members contributed more than $1 million to this fund, the newspaper reported.

The investment officer “was one of the university’s highest paid employees with more than $2 million in compensation in 2016,” the Free Press reported. “(His base salary was $690,000 in the same year.)”

Fitzgerald said there was "a real misconception" about the fund, which he said was not fully funded or operational.

"It's no different than an endowed professorship, of which we have hundreds on the campus, or an endowed position for the head coach or athletic director," he said. "It doesn’t provide any additional compensation. It's a way for donors who feel strongly about a particular program and want to support that program to help to keep the costs of the university down. It has zero impact on the level of compensation, it just changes the source of funding of who pays for that position."

The appearance that a gift was made to an institution with either the implicit or explicit expectation that it would then create income for a donor can be problematic on many fronts, said William Jarvis, an expert on investment policy and governance for endowed nonprofit organizations and former executive director of the Commonfund Institute, which promotes best practices in financial management.

“In a situation where a donor makes a gift and the perception is that the investment was in return for that gift, there’s potential for other donors to be discouraged and to not make a gift if they feel it was improper,” he said.

Jarvis is currently the managing director of U.S. Trust, Bank of America Private Wealth Management. He spoke about investment practices by colleges and universities in general, not about the University of Michigan or any other institution in particular. He said such practices also posed potential risks to an institution’s reputation.

“The appearance of improper relations can be compounded if the investment product does not perform well,” he said. “The risk there, with 20/20 hindsight, is that other donors or stakeholders could look at the institution and say you exposed yourself to improper risks because you did this thing. You took the gift, invested with the person who made the gift and then the performance was below par.”

Jarvis, who writes and lectures about best practices in investment strategy for endowments and foundations, said there are no separate or official standards or laws governing such practices “other than general fiduciary behavior standards that address conflicts of interest.”

Those standards include recusal, meaning the donor should not participate in discussions about managing the money -- “That doesn’t cleanse it, but it helps to manage the perceptions,” he said -- and transparency by the university about donors and management of investments. “Of course disclosure helps a lot,” he said.

“There are some institutions that acknowledge they engage in this practice and the reason that they give is that they want to have the services of people who are not only supportive of the institution but also skilled in matters of investment. I think that is a minority view,” he said. “The view that is more generally held is that this is not appropriate. The general view is that endowment investments should be done in an impartial way.”

Kent John Chabotar, founding partner of MPK&D consultants, an education strategy and leadership consulting firm, and the former president of Guilford College, agreed that impartiality is ideal when choosing investment funds, but he did not see impropriety in the University of Michigan’s decision to create an endowment fund to support the operating costs of the office of the chief investment officer, or for providing incentives for the CIO to earn additional pay.

Chabotar said successful CIOs are in high demand and work in a very competitive field.

“If I have a really good CIO and people are trying to poach him, I’m going to try like hell to keep him. If it happens to mean paying him two or three times what I’m making, so be it,” he said.

Chabotar also believes institutions could invest in funds managed by donors under the right circumstances and with full disclosure.

He recalled when he was chief financial officer at Bowdoin College, a donor whom Chabotar described as “a very loyal alum, very wealthy, relatively young” pledged $15 million to the college and provided $3 million in cash up front. The gift came with the stipulation that the $3 million would be invested and managed by the donor, who promised to grow the investment into the full $15 million.

“At the end of the due date, we didn’t get the $15 million,” Chabotar said. “We got $40 million.”

Although such arrangements are “usually bad practice,” he said, they can work when done with transparency.

“We didn’t hide it,” he said. “The board talked about it a lot. The school trustees endorsed and approved it. It occurred over three years, and all the i’s were dotted and t’s crossed. Everything was aboveboard.”

Although the college benefited from the arrangement, “I would not recommend it as a matter of course,” Chabotar said. “My concern was setting a precedent by having donors pledge money and not follow the investment procedures. I prefer one endowment and one company under central control.”

By allowing donors to manage investments, “You open up yourself to problems,” he said. “In this case it worked out fine, but just suppose in the course of making investments, the person goes way into debt with your money. You’re going to be on the hook for the money.”

He said the practices at Michigan have “the appearance of, and probably was, a conflict of interest” and should raise red flags, especially at a state-funded public university that has a large fiduciary duty to the state and its residents.

“If the decision is faulty and the endowment goes down as a result, then there’s less money to fund stuff like financial aid, faculty salaries and capital improvement,” he said. “I also don’t think students are well served by decisions made on personal relationships instead of merit. It’s a bad example for them.”

Dean Zerbe, national managing director of the Alliantgroup, a tax consulting services firm, agreed.

“Good luck firing the donor when the returns aren’t that good,” he said.

Zerbe said university administrators that overlook potential conflicts of interest and “self-dealing” in university investment practices aren’t asking themselves the right questions.

“What is lost in these endowment discussions is how is this helping students?” he said. “Where is the money going? What is the payout rate on these investments? Is it reducing costs? Is it making it possible to educate more students and admit more low-income students?”

Zerbe, former senior counsel to the U.S. Senate Finance Committee, said conflicts of interest by university board members or trustees and donors are not uncommon.

“This is kind of a constant problem,” he said. “People confuse doing well for themselves with doing well for a charitable cause. It’s for the board members to understand that they’re there for a charitable cause.”

Zerbe said a university should only use the investment services of a company owned or managed by a donor or trustee under conditions that are favorable to the institution.

“What you want to see is the donor doing it for free or heavily discounted,” he said.

Even better, Keating said, would be for the colleges and universities not to engage in any questionable investment practices in the first place.

“I think the simplest solution is to have an absolute prohibition saying, ‘We will no longer be doing these kinds of investments for the simple reason that it creates the perception of a conflict of interest,’” he said. “Anything that creates even the appearance of a conflict of interest should be eliminated in toto.”

“That should be the guiding principle and I don’t think it’s a very difficult principle to either implement or adhere to.”

Keating points to Yale University and its $27 billion endowment as a model.

“There’s no question in my mind that Yale has the best-run endowment in the country,” he said. “It has typically been at the forefront of governance in trying to eliminate conflicts of interest.”

He also noted that David Swensen, Yale’s chief investment officer for the past 33 years, is widely regarded as one of the best in the country and “has gone through great lengths to assure that Yale implemented and adhered to best practices.”

And because Yale has the second largest private endowment in the country, it also has the resources to put the best practices in place, Keating said.

“Smaller endowments look to the larger endowments, whether private or public, because they have the resources to put best practices in place,” he said.

Until more universities follow suit, the attention now being paid to Michigan will have far-reaching consequences on the investment practices of higher education institutions overall, Keating said

“People are going to say, ‘Michigan got raked over the coals and we should learn a lesson,’” he said. “I think Michigan will be the turning point and there will be less of that going forward.”

The tide may already be changing, and, ironically, Michigan may be helping to lead the way.

Soon after the Free Press investigation, the university announced new transparency measures about its investment practices "as a further expression of its commitment to transparency and appropriate governance regarding investments," according to a March 29 article in The University Record, a publication for faculty and staff.

The changes were announced at a Board of Regents meeting following a "review of the policies, procedures and practices that surround the Investment Office, and considering best practices," according to the article.

"The institution will move from verbal disclosure of potential conflicts of interest to written conflict-of-interest disclosure statements from members of the all-volunteer Investment Advisory Committee," Regent Andrew Richner said in the article. "A small number of the university's investments are in funds managed by members of the IAC. Going forward, should the university make new investments in such funds, it will call specific attention to them for regents to ensure transparency and prepare a plan to manage any perceived conflict. Additionally, the CIO (chief investment officer) will present the overarching investment strategy annually at a regents' meeting,"

Richner also said that committee members that have conflicts of interest related to discussions of an investment strategy "will be recused from any such discussion."

The board also recommended the committee redesignate the endowment for the university's chief investment officer "to a need-based student scholarship (or other areas of the institution, as selected by the donors) to avoid any perception of a conflict. The university will not accept any future donations specifically in support of the Investment Office."