Oct. 26 (Bloomberg) -- John L. Hennessy, president of Stanford University, is drawing on his 32 years of experience in Silicon Valley to speed up budget cuts, ditching a formula universities use to soften the impact of endowment losses.

Stanford’s endowment fell 27 percent to $12.6 billion in the fiscal year that ended Aug. 31. Hennessy has suspended the school’s so-called smoothing formula, which spreads losses over five years. The university, located near Palo Alto, California, said it dismissed 412, or 3.2 percent, of its non-faculty workers, in the first eight months of 2009, postponed $1.1 billion in construction and will close its 58,500-volume physics library.

Stanford will now reduce the amount it withdraws from the endowment over two years, leading to deep cuts designed to speed the university’s financial recovery, Hennessey said in an interview. Stanford, which has the U.S.’s third-largest university endowment, relied on the fund for 29 percent of its operating budget in fiscal 2009, the school said. As a result, Stanford will recover faster and gain efficiency, he said.

“It is only in those crunch times that we really say, ‘Which things no longer make sense?’” said Hennessy, 57, Stanford’s president since 2000. “That’s a healthy process. Not a painless process, but a healthy process.”

By making steep cuts, Stanford will be able to return to normal hiring and growth sooner, he said. In a typical year, Stanford hires about 110 faculty members, said Lisa Lapin, a Stanford spokeswoman. For the 2010 fiscal year, the school froze about 50 faculty searches.

25 Percent Cut

Universities use smoothing formulas to average increases or decreases in endowment returns over multiple years, protecting their budgets from sharp swings in the amount they withdraw from the funds annually.

Yale University, in New Haven, Connecticut, which saw its endowment fall 25 percent in fiscal 2009, continues to use its smoothing formula and will be making cuts through fiscal 2014, President Richard Levin said.

Rather than cut sharply like Stanford, “I took the opposite strategy, which is to do it in stages,” Levin said in an interview.

“We are still using our smoothing formula, so there will be tightness after this first couple of years,” Levin said. “We won’t start to see the endowment spending line turn up again for a few years, which means a certain amount of tightness.”

Princeton University in Princeton, New Jersey, which lost 23 percent of its endowment’s value, said it uses a different approach to regulate spending from the fund, setting a target of between 4 percent and 5.8 percent of the endowment every year.

Target Range

The school expects to “exceed our target range for the next few years,” Cass Cliatt, a Princeton spokeswoman, said in an e-mail.

Harvard University, in Cambridge, Massachusetts, which had a 27 percent endowment loss, hasn’t changed its approach to regulating endowment spending as a result of the fund’s decline, said John Longbrake, a spokesman. He said Harvard expects to spend a higher proportion of the endowment in the short term given the change in the fund’s value.

Stanford’s smoothing formula called for the contribution from the endowment to be reduced 13 or 14 percent over two years. Instead, the school is cutting the so-called payout 25 percent over two years from $933 million in 2009, Chief Financial Officer Randall Livingston said. Stanford’s fiscal 2010 budget is $3.6 billion.

The steep reductions should prevent future budget trims, Hennessy said.

Making Sense

“Think about doing cuts year after year of 5 percent, 7 percent, 8 percent and long after the markets have recovered,” Hennessy said in an interview in his office, cluttered with artifacts from Stanford’s 123-year history. “Now think about saying, ‘We’re going to lay off 50 people this week, forget that the rest of the economy is booming.’ It just doesn’t make any sense.”

Hennessy, an electrical engineer, joined Stanford as an assistant professor in 1977. He founded MIPS Computer Systems Inc., a designer of microprocessor chips, during a sabbatical year in 1984. At MIPS, he said he fired about 25 workers out of 175 to 200 in 1986 to stay in business after expanding too quickly.

The job cuts at MIPS, which sustained the company so it could go public in 1989, taught him that it is better to “take your medicine and move on,” Hennessy said.

Other Positions

Hennessy is also co-founder and chairman of Atheros Communications Inc., a wireless technology company based in Santa Clara, California, that first sold shares to the public in 2004. He serves on the boards of Google Inc., based in Mountain View, and Cisco Systems Inc., in San Jose, California.

Stanford’s endowment grew to $17.2 billion on Aug. 31, 2008, from $4.7 billion a decade earlier. That growth justified investment risks that led to the fiscal 2009 decline, Hennessy said. The loss “might be a 50-year or 100-year event,” he said.

Stanford’s endowment is tied with Princeton’s as the third- largest fund in U.S. higher education. Harvard has the largest endowment, valued at $26 billion on June 30, followed by Yale at $16.3 billion.

Stanford is prepared to wait decades before the endowment regains its 2008 value, Hennessy said. If the investments increase 8 percent to 10 percent a year, inflation is 3.5 percent and school spends 5.5 percent of the fund annually, the endowment won’t recover for more than 30 years, Hennessy said.

Bond Sale

“That’s the realistic way to look at it, rather than say ‘I’m going to hold my breath and hope to get through this without making strategic changes,’” Hennessy said.

In April, Stanford raised $1 billion in a bond sale to create a cash reserve. In the future, universities will have to consider the value of liquidity when making investments, Hennessy said.

“We may say, because of liquidity concerns, we can’t afford to be as locked up in private equity or commercial real estate, and are there other asset vehicles that will deliver similar returns with a similar risk profile?” Hennessy said.

Stanford will also consider different private equity agreements which don’t commit the school’s cash, he said.

“All of these things need to be re-contemplated,” he said.

Stanford is seeking to raise as much as $1 billion from the sale of stakes in private equity, venture capital and other illiquid holdings, said John Powers, chief executive officer of Stanford Management Co., which oversees the school’s endowment. The goal is to take advantage of improved pricing in the secondary market, not to raise cash, he said.

Financial Immersion

Hennessy’s approach to management comes from his immersion in the financial world, said Robert L. Joss, the former dean of Stanford Graduate School of Business, who retired Aug. 31 after 10 years at the school.

MIPS, now called MIPS Technologies Inc. and based in Mountain View, California, went public in 1989 and was bought by Silicon Graphics International Corp., of Fremont, California in 1992. It was spun off again in 1998.

“If you’ve just spent your whole life in academia and grown up in the faculty, it’s easy to lose track of economic realities and where money comes from and where money goes,” Joss said. “If you have a little bit of a business background, it helps you to act, instead of just being intellectually curious.”

Builds Support

Hennessy’s ability to win support from the university community has been as important to his success as his corporate past, said William R. Brody, a Stanford trustee and president of the Salk Institute for Biological Studies, in La Jolla, California. In business, the CEO has more power to force change than a university president, who may have to contend with angry faculty, alumni and students, Brody said.

“You’re going to have a lot of constituents coming at you,” said Brody, the former president of Johns Hopkins University in Baltimore. “When Jack Welch was at General Electric, people didn’t push back.”

Hennessy has also benefited from a governance structure at Stanford that puts more control in the hands of its president than at Harvard or Johns Hopkins, which both give budget responsibilities to individual units or colleges, Brody said.

Hennessy’s business background leads him to make budget decisions before consulting the people most affected, said Daniel Weissman, a member of the Stanford Labor Action Coalition, a student group that supports campus workers. Weissman said the university held meetings with students to explain decisions already made, not to solicit opinions.

Yell Louder

“We’re all smart people here -- this is Stanford -- but somehow the administration doesn’t really trust us or believe we have anything to contribute to the conversation,” said Weissman, 25, a physics graduate student. “I’m afraid they have the attitude that if there wasn’t enough input, it was our fault for not yelling at them loud enough.”

Students fasted earlier this year to protest budget cuts at community centers that provide services for minority groups. Graduate students are also fuming over a new mandatory fee for campus health services that will cost up to $668 a year. That’s a significant additional cost to attend the university, said Eric Osborne, 28, a law student who co-chairs the Graduate Student Council.

“We think a fee like this is going to make Stanford less competitive for graduate students,” Osborne said. “I don’t think Stanford has thought this through.”

The university needs the health fees to provide medical services, Stanford said on its Web site. No fulltime employees were fired at the community centers, the school said.

Leland Stanford

Stanford was founded in 1885 by Leland Stanford, a railroad baron and former governor of California, in honor of his son, Leland Jr., who died of typhoid fever at age 15. Alumni include Herbert Hoover, the 31st president of the United States; Sergey Brin and Larry Page, co-founders of Google; and Supreme Court justices Stephen Breyer and Anthony Kennedy.

While the spending reductions aren’t immediately visible on the Stanford campus, where yoga classes are held under pine trees and construction is proceeding on a new $350 million business school, students say they’ve noticed less money is available.

Among the programs eliminated was a peer-advising system that paid 40 juniors and seniors to counsel freshmen and sophomores, Lapin said.

Physics Library

Stanford will save “hundreds of thousands of dollars annually” by closing its physics library, said Michael A. Keller, the university librarian. That facility, one of 21 Stanford libraries, was chosen because most physics literature is available electronically, Keller said. The school will also reduce its $25 million annual budget for new books and journals by about 10 percent, he said.

“We got used to the fact that everything could get funding,” said Julia Brownell, 19, a student from Menlo Park, California. “Now, we have to get used to the idea that funding is hard to come by.”

To contact the reporter on this story: Oliver Staley in New York at ostaley@bloomberg.net

Last Updated: October 26, 2009 00:01 EDT