The Evolution of Investing at the University of Michigan

Chapter Eight: Working Capital Pools and Other Investments

In addition to its endowment investments, the University has always held funds that do not constitute “true endowments”—that is, funds whose “principal” is not required to be preserved, but can be spent if required—as well as working capital, or operating, funds central to the University’s liquidity plan. It is worth keeping in mind that the term “working capital” is sometimes used as a catch-all to include funds that are not actually being reserved for day-to-day operations as working capital in the strict sense but that also do not fit within the parameters for investment in the endowment’s Long Term Portfolio (LTP). For reference, the chart on the next page traces the size of the University’s working capital pools from 1930 through 2016, in 2016 dollars according to a CPI index adjustment (Exhibit 83, below). Interestingly, for a period (say 1977 through 1993), the working capital pools were actually larger than the endowment pools.

Historically, all these funds were called the “University Investment Pool,” or UIP,[33] and were, as might be expected, invested in cash or liquid fixed-income securities. For example, in May 1988, the “University Investment Pool Investment Guidelines” were updated from guidelines that restricted the purchase of bank obligations to banks that are among “the twenty-five largest banks in the country based on deposits” to obligations of banks, holding companies, or thrift institutions that met minimum credit ratings (Exhibit 84). The item noted: “The requirement of selecting a bank based on its level of liabilities is inappropriate because this ranking does not reflect the institution’s financial soundness.” The new guidelines would “provide diversification while maintaining the high quality rating standard of the University Investment Pool.” Regardless of the modification, this item demonstrates that the UIP was historically very conservatively invested, with a focus on the preservation of principal.

In November 1992, the UIP guidelines were modified to permit international bond investments, more specifically in the Common Fund’s “Global Bond Fund.” The Global Bond Fund made investments in high-quality credit obligations denominated in different currencies worldwide. Much of the item focused on the potential risks and returns of the non-U.S. currency exposures that could result from this diversification, although, at the time of this item, the Global Bond Fund was heavily (80%) weighted to the U.S. dollar.

As described above, April 1994 brought what is probably the most significant change in policy for the UIP. A large amount of capital, more than $900 million, had accumulated in the UIP where it was invested primarily in high-quality short to intermediate maturity fixed-income securities, as well as in three funds (one of which was the Global Bond Fund). This was far in excess of what was needed for working capital purposes and represented, due to the highly conservative nature of the investments, a significant opportunity cost. So it was decided to invest a “permanent core” of the UIP into the endowment portfolio with the expectation of achieving a higher return over time driven by the longer-term, equity-based, and alternative, investments in the University Endowment Fund (UEF) (see Exhibit 55).

As part of this change of policy, new accounting constructs were put into place. A new endowment portfolio was created, the Long Term Portfolio, or LTP; the UEF would now become just one participant in the LTP. Also, the concept of “Internal Bank” was introduced. The Internal Bank would sit on top of the UIP by holding investments in working capital portfolios (UIP) as well as the “quasi-endowment” investment in the LTP.[34]

Also described above, in March 2001, the Board of Regents approved an item that confirmed the authority of the Executive Vice President and Chief Financial Officer to designate “Funds Functioning as Endowment” (quasi-endowment) and made it clear that such funds should generally be locked up for a minimum of 5 years (see Exhibit 69). Months later, in October 2001, Internal Bank Procedures were approved by the CFO, adding details to the quasi-endowment policy. It is interesting to note that at this point, the quasi-endowment investment target had been reduced to 25% of Internal Bank assets (Exhibit 85).

A few years before, in November 1998, another important change had taken place. UIP investments, all fixed income that had been internally managed up until this point, were now also given to external managers—many years later than had happened for the endowment investments. The University engaged Pacific Investment Management Company (PIMCO) and Payden & Rygel as active fixed-income managers. A passive manager was to be selected as well (Exhibit 86).

In July 2004, the liquid (non-quasi-endowment) investments of the Internal Bank/UIP were reorganized and unitized into two new portfolios: the Daily Portfolio and the Monthly Portfolio. The Daily Portfolio would permit daily liquidity, and the Monthly Portfolio would permit monthly liquidity. The new structure had several advantages: (i) it allowed the University’s self-insurance and gift programs to invest into the working capital portfolios (previously these programs had their own portfolios, which was inefficient), (ii) it allowed for cleaner layering by liquidity and risk of the working capital investment program, and (iii) related to the prior point, it allowed the Monthly Portfolio to invest a portion of its assets in “value-add strategies” to supplement its core fixed-income holdings. These value-add strategies would typically be higher returning but often less liquid, although still generally fixed-income oriented (Exhibit 87).

Thus, in February 2004, the Board of Regents approved the first value-add strategy for the Monthly Portfolio, an investment in Prospect Harbor Credit Partners, a fund managed by an affiliate of Bain Capital. The fund would invest in “non-investment-grade corporate debt . . . primarily in liquid credit instruments including syndicated, floating-rate bank loans; high yield bonds; and credit default swaps” (Exhibit 88).

Going forward from 2004, a portion of the assets of the Monthly Portfolio would be allocated to a diversified portfolio of value-add, income-oriented investments to supplement its core holdings of lower-yielding fixed-income assets.

In October 2008, a more sophisticated, liquidity-based policy for the quasi-endowment investment of the Internal Bank was put into place (Exhibit 89). According to this policy, which is still in effect today, the “maximum liquidity allocated to the Long Term portfolio will be 60% [of Internal Bank assets], with a trigger for reallocation at 65%.”

Starting with 2011, a new internal construct was implemented. Called the “Short-Term Pool” (STP) to contrast with the LTP, the STP simply represented the Internal Bank’s investments in the Daily and Monthly Portfolios, thus excluding the Internal Bank’s quasi-endowment investment in the LTP. Thus the STP now represents the University’s working capital pool. The STP can be viewed as a replacement concept for the UIP, which had become a somewhat confused concept over time due to the various changes we have described. The last reference to the UIP was in the 2009 Report of Investments.

The following table traces how the target allocation for the Internal Bank has changed over time:

And then the actuals:

And finally the difference between actuals and target:

Starting in July 2013, a new benchmark was implemented for the Monthly Portfolio. Previously, the benchmark for the Monthly Portfolio had been a value-weighted “roll-up,” or consolidation, of the individual benchmarks for each of the funds or separate accounts in the portfolio. There were various issues with this approach. First, the roll-up benchmark by its nature did not provide policy guidance; thus there was no way to perform asset allocation or style attributions. Second, allocating an individual benchmark to some value-add strategies could be arbitrary and problematic. Third, some of the individual benchmarks were not investable. And finally, the roll-up benchmark was required to be changed every time a new manager was added or dropped. Now a true investable policy benchmark was adopted, more analogous to the approach taken with the LTP since the implementation of the Model Portfolio.

The principal endowment portfolio (LTP) and the working capital portfolios (STP) by far make up the bulk of the University’s investment assets. Nonetheless, there are some other vehicles of which to be aware. Exhibit 90 sets forth a chart of the University of Michigan’s Investment Structure as of June 30, 2016. It shows the LTP, STP, Daily and Monthly Portfolios, the quasi-endowment investment, and the connections between them, all of which we have discussed. In addition, it shows the University’s self-insurance vehicles—“Veritas” and the Long-Term Disability (LTD) plan—are invested in the LTP and the Daily and Monthly Portfolios. In addition, there is a set of donor vehicles called “Life Income Funds,” which is also invested in the LTP. Finally, there are certain assets that, for various reasons, are invested outside the main portfolios but controlled by the University (see the right side of the chart); these types of assets are broadly designated as “specifically invested.” Finally, there are “External Trusts” for which the University is a beneficiary, but these are not controlled by the University and are not consolidated in its financials.

Of course, in addition to investment assets, the University has significant capital assets used in its operations—in particular, real estate (including land), equipment, and library materials. Exhibit 91 sets forth Note 5 of the University’s Financial Statements for the fiscal year ending June 30, 2016, listing the value of those assets in broad categories.