The world of tax-free hedge funds

AKA "Ivy League Universities"

Receipts = $2 billion of operating revenue + $7.3 billion of investment income + $0.6 billion of gifts to the endowment = ~$10 billion.

Operating costs = ~$3 billion.

Profit = $10 billion – $3 billion = ~$7 billion.

This explains why Harvard’s net assets increased about $7 billion in 2007, from about $35 billion to about $42 billion.

Viewed purely in terms of economics, Harvard is really a $40 billion tax-free hedge fund with a very large marketing and PR arm called Harvard University that has the job of raising the investment capital and protecting the fund’s preferential tax treatment.

The trick is that this hedge fund can’t remit earnings to investors, and has to keep them in the company’s account, renaming these retained earnings as an “endowment”. So how do the insiders extract value from this business? One way is by giving themselves cushy jobs that pay a ton of dough.

[Source: Jim Manzi]

To be fair, the fact that it can't remit earnings to investors, but must keep them in its endowment and use them to further its mission is very significant from a social standpoint. Sure, it's making tax-free profits, but those are tax-free profits that can only be spent on education and research. Which is somewhat different from private profits that are spent on consumption, or corporate profits that are partly returned to investors for consumption.

Still, I definitely don't buy the idea that money Harvard spends is better for society than corporate profits which are reinvested. I mean, sure, Harvard may invest in things which are not profitable but yet still socially beneficial (perhaps because benefits are widely dispersed). But they also invest in things which are not profitable because they have less social benefit than their cost.

The freedom to not try to make a profit lets you do things that accomplish enormous dispersed good, or are wasteful. I see no reason to think that the average result gives the world more utility than investment in private corporations. I'd guess less, actually. So the favorable tax treatment is actually encouraging malinvestment.

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Yes, But...

Harvard may have a longer time horizon than many other investors. The typical institutional investor wants something that gets a slightly above average return with low volatility, even if it includes the 1% annual chance of a total blowup. Harvard's investment profile can lean towards the strategy that usually loses money, but occasionally makes a huge sum very fast (ideally when everyone else is bailing).

Also, Harvard used to invest directly in Sowood Capital which, ironically, blew up. Harvard can't pay its endowment manager 2 and 20, or even 1% of assets, but it can pay him .1% of assets to invest in his friends' funds which pay said friends 2/20. Sowood was basically ex Harvard people who restructured so they would get more fees. If they're not the first, perhaps Harvard's managers are sort of like Mafia dons or party bosses, who can dole out lots of money but get compensated mostly through the influence that this ability gives them.