A Billion Dollars in Nine Months

Author: Ed Cohen

It’s late April, 2000, and Scott Malpass, vice president for finance and senior investment officer at Notre Dame, convenes a meeting of his investment staff.

He needs their help to finish preparing for the regular meeting of the Investment and Finance Committee of the Board of Trustees, four days hence. It’s a meeting, he knows, at which the Investment Office will have some explaining to do.

The committee, which consists of 13 trustees, sets policy on how Malpass, a 1984 undergraduate and 1986 MBA graduate from Notre Dame, and his staff may invest the giant pool of money consisting of the University’s endowment, working capital, and funds reserved for operating and maintaining facilities. What Malpass will be attempting to explain is how the Investment Office did something unimaginable: It made over a billion dollars in nine months.

On July 1, 1999, at the start of the University’s last fiscal year, the value of Notre Dame’s investment pool, of which the endowment constitutes 85 percent, stood at $2.2 billion. By the end of the third quarter, March 31, 2000, it had grown to $3.3 billion. Of that increase, only about a hundred-million dollars came from additional gifts to the University and transfers-in of other funds. The rest was generated by the performance of a wide array of investments directed by Malpass and company.

According to figures compiled by Cambridge Associates, a major investment consultant to higher education, Notre Dame’s endowment — the nation’s 18th largest — outperformed every one of the 30 largest during the second half of 1999, when it earned 25 percent. (Rankings that include the first months of 2000 weren’t available as of this writing.) During the nine months ended March 31, the endowment earned 49 percent, and going back 12 months it was up 62 percent, marking the best 12-month period in the endowment’s 80-year history.

There’s more than one reason for the huge success. Last year’s furious run-up in growth and technology stocks, in which the endowment was heavily invested, helped plenty. But the single biggest factor involved an investment category Notre Dame barely touched a decade ago.

Anyone who has ever used the Internet has heard of Yahoo, the search engine and World Wide Web portal. Some people may recognize the names David Filo and Jerry Yang, the pair of electrical engineering Ph.D. candidates at Stanford who devised the search system in1994 as a way to keep track of their personal interests on the then-infant web.

Fewer people have probably heard of Michael Moritz, a partner in a Silicon Valley venture capital firm that provided Filo and Yang the money to start their business. Fewer still know that part of that money came from Notre Dame.

Moritz is a partner in Sequoia Capital, an investment partnership that specializes in locating and then buying in on promising new technology companies. He heard about Filo and Yang’s Internet “guide” early on and drove down to Stanford to talk with them. With Sequoia’s capital and advice, he told them, they could build a business. And so they did.

But rewind a year to 1993 and cut across the country from Stanford to Notre Dame, specifically to the Main Building office of Malpass. The University’s young chief investment officer — then four years on the job but still only 31 — had convinced his superiors and the trustees’ investment committee to consider diversifying the University’s investment strategy. His idea: to rebalance some of the more conservative investments (about a quarter of the fund was anchored in bonds with most of the rest in large-company stocks) — with more innovative, if higher-risk, investments. The goal: to reap higher overall earnings from the pool.

Notre Dame had stuck a toe in the water of venture capital — the business of providing seed money to a new business in return for part ownership — in 1980, when it contributed to a fund organized by a Boston firm, Charles River Ventures. But venture capital and initial public offerings (IPOs) didn’t draw a great deal of attention in the 1980s as established stocks were enjoying a bull market. Malpass came to Notre Dame in 1988 as assistant investment officer after working at New York’s Irving Trust Company as an investment consultant to large pension funds; he also managed an index fund. As he studied what other universities with sophisticated and successful investment programs were doing, he noticed that many devoted a significant portion of their portfolio to venture capital. Helping launch companies capable of advancing technology and improving quality of life seemed to him to fit with Notre Dame’s identity.

“At the time I think we had a couple of investments in venture capital, less than 1 percent of the endowment,” Malpass recalls. “I thought, if we’re going to do it, let’s do it.”

He convinced the trustees to target 5 percent of the endowment for venture capital. The next step was finding the right venture capitalists.

Lacking a staff, it was primarily a personal search for Malpass. By 1993, he had made more than 20 trips to Silicon Valley and other areas to meet with executives of proven business-discover/builders like Sequioia Capital, which put some of its first money into Silicon Valley stalwarts Oracle and Sisco Systems. Malpass let Sequoia know Notre Dame was interested in becoming a partner in any future investments in technology company start-ups. Now, in 1993, Sequoia was looking for partners in a $100 million fund._ Did Notre Dame want in?_ With the approval of the trustees, Malpass committed the University to contributing $3 million.

Yahoo became just one of dozens of then-unknown enterprises Sequoia spent portions of the $100 million to help launch. But it turned out to be among the most lucrative. For a total investment of less than $2 million Sequoia received nearly a third of the company, which became worth $57.6 million a year later when Yahoo Inc. stock debuted on the Nasdaq at $13 a share. (The stock has sold for as much as $500 a share in the past year).

As a $3 million contributor to a $100 million fund, Notre Dame’s share of the Yahoo seed money amounted to a measly $18,163, and that entitled the University to a similarly small portion of the Yahoo stock. Even so, when Notre Dame received its distribution of Yahoo stock from Sequoia some months after the initial public trading, the shares were worth $27 million. That’s a return of nearly 150,000 percent.

Not every company Notre Dame has had a hand in launching has paid off lottery-style like Yahoo. For example, the University contributed $7 million in 1995 to a $150 million fund raised by another venture capital firm, Oak Investment Partners. One of its beneficiaries was Zany Brainy, a chain of stores that sells educational and quality children’s toys.

Notre Dame’s share of the Zany Brainy seed fund amounted to $156,210, and five years after contributing the money the University received $321,329 in Zany Brainy stock. That works out to an annualized return of 14.5 percent.

So not all of the venture capital investments have been home runs. But the overall batting average has been terrific. The venture cap sector of the endowment returned 339 percent in the past year and has averaged just over 100 percent a year for the past three years and 74 percent a year for the past five.

At their meeting in late April, Malpass and his staff of investment managers find themselves with more to do than prepare for the trustees’ meeting. There is also the matter of asset management — where to shift money based on the latest economic news and forecasts.

With the trustees’ approval, the Investment Office targets what percentage of the pool is to be invested in specific areas like domestic stocks, foreign stocks, bonds, commodities (oil, precious metals, etc.) and other sectors. Looking over the latest report, Malpass notes that the bonanza in venture capital has thrown everything slightly out of whack. Venture capital is supposed to constitute 22.5 percent of the pool, but the figure has ballooned to 30 percent. No one is eager to exit this particular gold mine, but the managers discuss shifting funds among other areas.

There is general agreement that a tepidly performing real-estate investment trust is ripe for liquidation. Dumping it would free up $20 million, which Malpass is keen on rolling over into domestic “value” stocks — shares of often-familiar companies with lower price-earnings ratios and higher dividend yields than more-speculative growth stocks.

No mention is made of what specific value stocks to buy, however. That’s because Notre Dame doesn’t buy individual stocks any more than it sends employees out looking for the Yangs and Filos of the world. Instead, the investment team scours the world to identify the most successful fund managers at companies like Morgan Stanley Dean Witter, T. Rowe Price, Alliance Capital and less familiar names. Notre Dame pays these firms annual management fees, averaging about a half-percent of the amount invested, to know their markets and make the trades that will make the most of the money. The managers invest the Notre Dame money separate from any mutual funds they may offer to the general public.

Malpass says every year the Investment Office interviews 250 to 300 investment firms, many of which send representatives to South Bend. But he and his staff also spend an estimated one-third to one-half of their weeks on the road and probably a quarter of that time abroad. “This is a business that’s just a lot of legwork,” he says. “You don’t just sit in your office and good things come to you.”

This sort of exhaustive investigative work would have been impossible 12 years ago. When Malpass became chief investment officer, he says, the department consisted of him, an accountant and a secretary. A year or two later, after the officers and trustees had agreed to the more diversified investment strategy, he got the go-ahead to build a modern investment office. Today the staff numbers 18, including the five — soon to be six — professionals who ride herd on segments of the investment pool and search out the top managers in those areas.

“We have about 70 different [investment] firms and over 130 portfolios now if you count all the partnerships. Twelve years ago we had 10 firms and 12 portfolios,” Malpass says.

The rest of the staff handles the movement of money and securities, which amounts to about 50,000 transactions a year — 20 times the volume of 10 years ago, he says.

Malpass says that as a result of what he calls the office’s “due diligence” in vetting fund managers before handing them Notre Dame’s money, the University hasn’t had a single fund lose money during his tenure. “That doesn’t mean that all have lived up to expectations. We’ve had four or five who haven’t performed to expectations.”

When that happens, he “fires” them, meaning the office withdraws the money from their care. This happens every couple of years, he says.

The University has similarly high expectations for Malpass and his staff — most of whom are Notre Dame graduates, including the entire senior investment team. So far they have proven their worth. The trustees continually compare the actual performance of the investment pool with what the money would have earned if left on the equivalent of an autopilot set up to mirror the trustees-approved investment category targets. Over the past 10 years, the Investment Office’s actual returns have beaten the hypotheticals by an average of 3.5 percent annually, including a gaudy 27 percent spread for the 12 months ended March 31.

That 3.5 percent average translates into Notre Dame having a billion dollars more today than it would have without the investment team’s active management.

One might ask, “If the endowment is doing so wonderfully in the Investment Office’s hands, how come Notre Dame continues to ask for donations and raise tuition?”

First, the impressive returns have helped ease the financial burden of students. Because of the endowment’s performance, and Notre Dame’s success in fund-raising, the most recent increase in tuition and fees — 5.2 percent for this fall — is the lowest in 20 years. Also, the University is awarding more than twice as much financial aid today as it did five years ago.

But $3 billion seems like it ought to buy more than just a boost in scholarships and a leveling off of tuition hikes.

“People say, ‘You’ve got $3 billion, why don’t you spend it?’” says Father. E. William Beauchamp, CSC, who was executive vice president of the University from 1987 until July 1, 2000, when he became executive vice president emeritus. “First of all, how you spend the endowment is determined by the donor.”

The pool of money and stocks and other investments instruments usually referred to as the University’s “endowment” is composed of more than 2,500 individual endowments. Each of these started out life as a gift that was made to the University with the stipulation that the gift amount would not be spent but would be invested. Only the investment earnings from an endowment gift — the income and a portion of capital gains — are available to be disbursed annually. Those earnings can be spent only as specified by the donor. Typically they fund a scholarship, or pay all or part of a professor’s salary (an endowed chair), or finance all or part of the operation of an academic center or institute. Obviously the more expensive the intended purpose, the larger the initial gift has to be to generate enough earnings dollars. An endowment gift keeps on giving forever, but the money can be spent only on what the donor thought worthy.

“If the donor says it’s going to be spent for scholarships, it’s going to be spent for scholarships,” Beauchamp says. “We can’t just say we’re going to use it for chaired professors. There’s a perception that this $3 billion is out there to spend any way we want. But all but a small proportion of it is restricted to specific purposes.”

In fact, only about 10 percent of the endowment is unrestricted. Fortunately, the areas to which most endowment earnings are restricted — scholarships, faculty positions, library collections — are the same areas Notre Dame would be spending lots of money on anyway. So it all helps the bottom line.

Malpass says, “The more endowment money we can get for various academic programs, faculty chairs, the library — things like that — the more we can keep tuition down. It all does tie together, and it’s very powerful.”

Donor restrictions may keep the University from spending the endowment all in one place, such as on financial aid. But one may wonder why the University can’t lavish more money on those worthy restricted areas at times — such as now — of exceptional endowment earnings.

It is within the trustees’ power to do so, but it wouldn’t make sense in the long run because no one knows what tomorrow’s endowment earnings will be. That’s why, since 1989, the trustees have followed a disciplined formula for drawing off funds from the endowment. Each year the University is allowed to spend only about 5 percent of an amount equal to the average value of the endowment during the past three years.

“The thinking is that the real return [of the endowment] over time, after inflation, will be 5 to 6 percent long term,” Malpass says. “The real return recently has been much higher. Inflation has been low, and the market’s been great. But from 1968 to 1982, the real return of the stock market [taking into account inflation] was negative. So you’ve had long periods with no real returns or even negative returns. That puts this period more in perspective.”

This wasn’t always the policy. In decades past, the University spent not a percentage of the endowment’s value but whatever its current income amounted to, Beauchamp says.

“But if you do that, your base doesn’t grow. If you invested a million dollars back then and earned 10 percent interest every year and you spent all the interest, 20 years later you’d still only have a million and in the meantime you’ve had inflation.”

Even if the University has chosen not to spend all the money the endowment has been earning of late, that doesn’t mean the boon isn’t being felt. Some gifts that were made to endow a single faculty position long ago have grown so large through continual reinvestment of excess earnings that they now generate enough to pay for a second faculty position or to support graduate assistants. Likewise, endowed scholarships have been able to increase the amount they award or have become multiple scholarships.

One of the great aspects of an endowment, Malpass says, is that it ensures that the academic experience for students 20 years from now will be as high in quality as it is today. “And hopefully better.”