Tax-free Hedge Funds... But Only for the Big Schools Like Harvard

This is a very interesting article posted on the American Scene blog. It raises some important questions about the non-for-profit organizations, that, even though the don't give dividents to shareholders, they do provide excellent benefits to those involved. As we all know, many not-for-profit institutions are money makers. But, if we are to re-examine the taxation policies, we shouldn't just limit ourselves only to secular institutions.... (if you catch my drift)

Is Harvard Just a Tax-Free Hedge Fund?
According to the Wall Street Journal, Massachusetts legislators are studying a plan to levy a 2.5% annual tax on the portion of college endowments that exceed $1 billion. The high-wage union workforce with lifetime employment contracts and restrictive work rules tenured faculty is not amused.

Harvard’s official response is pretty funny:
Kevin Casey, a spokesman for Harvard, said the proposal would hurt Massachusetts and colleges because it would damage “stable bedrock institutions” that have helped shield the region from the worst of the economic slowdown.

But why isn’t this statement true of, say, Akamai, Biogen and Raytheon?
I’ve purposely picked companies with close ties to MIT and Harvard, because one could argue that universities create spin-offs that ultimately create corporate profits to be taxed. But large tech companies do the same; many successful companies are in the fourth or fifth generation of this process. Should Fairchild Semiconductor be free of paying corporate income tax because employees left to create Intel, or should this tax benefit revert to AT&T because a group of employees left Bell Labs to start Fairchild?

Which brings to mind another obvious question: why do endowed universities get tax breaks that other corporations don’t get in the first place?

Consider Harvard.
It claims to be in the business of serving humanity through the creation and dissemination of knowledge, but Biogen claims to “transform scientific discoveries into advances in human healthcare”. That sounds pretty good, too. If you think of Harvard as a corporation, it had an income statement in FY 2007 with about $2.2 billion of revenues (tuition, sponsored research contracts, and so on) and about $3.2 billion of expenses, and therefore had to move about $1 billion from the endowment to make up the difference in order to run at basically break-even. In other words, it’s a big institution, but hey, it doesn’t make any money and has to survive on the kindness of donors, even if these donations are channeled through an endowment.
But this isn’t quite the whole picture.

The overall Harvard corporation gets to make money through investment returns on its endowment (or, more precisely, the General Investment Account, which currently includes about $6 billion of investable assets in operational accounts in addition to the $34 billion endowment) that doesn’t get reported as revenue. Last year, Harvard made more than $7 billion of tax-free investment income.

So if you just think about how much cash went into the shoebox and how much came out of it, a more accurate accounting for Harvard for FY 2007 would, in rough numbers, be a lot more like the following:

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. Those who manage Harvard’s money are well-paid.

The prior investment head, Jack Meyer, left after criticism of a compensation plan that paid some investment management professionals more than $35 million each in a single year. In spite of this, investment professionals often leave the Harvard Management Company because they can make yet more money as partners in private equity groups or hedge funds. Of course, the qualification of running Harvard’s pool of assets can be leveraged to get exactly such jobs – those who do this are called “Crimson Puppies” – while in the meantime enjoying a somewhat more relaxed work-life balance, and not having to do the hard work of actually raising the fund.

The worker bees in the marketing department (i.e., the faculty) are also quite well-paid. The average Harvard professor now has a salary of about $185,000 per year. Professors in the right disciplines, such as business, can reportedly double their salaries through outside consulting and other income sources. In 1980, the salary of a Harvard professor was about 5.5 times the average US per capita income; today, $185,000 is about 7 times the average national per capita income, and can often be leveraged into much higher actual annual compensation.

When tax-advantaged non-profits start to accumulate billions of dollars of cash through investment gains, and the insiders seem to be doing very well, it creates legitimate pressure for some legal changes. There is a broad range of alternatives: capital gains taxes on investment income, directly taxing the endowment, placing limitations on employee compensation, and forcing the distribution of a fixed percentage of the endowment are all obvious choices. Sanctimonious talk about “the mission of the university” is not likely to stop this; unfortunately, giving lots of money to Democratic politicians very well might.