Veritas, and big returns.

How Harvard Minted 'Free Money'

Stephen Mihm, an associate professor of history at the University of Georgia, is a contributor to the Bloomberg View. Follow him on Twitter at @smihm.
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It’s the time of year when elite universities vie for bragging rights about the performance of their endowments. The probable winner this year is Yale University, which posted a whopping 20.2 percent return. Dartmouth reported a 19.2 percent return, and the University of Pennsylvania showed 17.5 percent.

Harvard, the 800-pound gorilla of the endowment world, reported a measly 15.4 percent. Not coincidentally, it installed a new chief executive officer for Harvard Management Co., which oversees the university's $34.6 billion nest egg.

How did this competition among "non-profit" universities come to extend from sports and academics to financial prowess?

Universities have long had endowments: permanent funds that generate annual returns. But until the 1890s, most institutions made no concerted effort to pursue high rates of return, much less expand the underlying endowment. In fact, most donations to universities typically went to cover shortfalls in operating funds.

The profile of the average college administrator helps explain this blasé attitude to money. In the mid-19th century, most Ivy League presidents hailed from the ranks of the Protestant clergy: affable theologians with considerable academic training and limited knowledge of financial matters. Enter Charles W. Eliot, Harvard's 21st president. When he took over in 1869, it was a sleepy little college. By the time he left in 1909, he had bequeathed an educational powerhouse that had established an almost insurmountable lead in the race to become the world’s richest university.

As historians Bruce Kimball and Benjamin Johnson have documented, Eliot advocated what became known as the “free money” strategy for achieving academic greatness -- a reference to the unrestricted funds generated by the investments that comprise the endowment.

Eliot summarized his philosophy with remarkable bluntness. “In the competition between American universities, and between American and foreign universities,” he wrote, “those universities will inevitably win which have the largest amounts of free money.”

This candor earned him the scorn of his fellow university presidents. Martin Anderson, at the University of Rochester, said Eliot “never teaches the students and has not the least formative control over their minds or characters.” The Harvard president, he sniffed, “is really a sort of general manager with duties analogous to those of a superintendent or president of a railroad.”

Indeed. Eliot approached fundraising with a businessman’s eye. Instead of putting his faith in occasional big gifts, as most universities did, he sought to raise funds through smaller, consistent bequests. Although other universities might land flashier gifts, Harvard quietly inaugurated a more broad-based, comprehensive fundraising campaign.

The innovation was in asking donors to direct the bulk of their money toward the permanent endowment. For example, Kimball and Johnson found that in 1898, 89 percent of the gifts to Harvard went to the endowment, most of these consisting of a “multitude of small gifts.” Yale, by contrast, undertook an alumni campaign that same decade, with only 9 percent of the funds going to the endowment.

Eliot was dismissive of Yale's strategy of encouraging donors to fund buildings. “Buildings get out of fashion and decay,” he observed, “but the permanent funds which have come down from those centuries are still doing the very work which the givers meant them to do.” Eventually, Eliot refused to accept gifts for buildings unless they came with an endowment to cover maintenance.

Eliot’s unswerving focus on the endowment meant he had little interest in relying on tuition or fees. A focus on fees, he wrote, “is extremely undesirable” because it threatened the university’s stability and independence. Scientific research, for example, needed a guaranteed supply of funds that could be tapped year after year. Only a permanent endowment could provide that stability.

This dogged approach to accumulating capital led one critic to liken Eliot to “a skillful manager of a cotton factory,” but Harvard’s famed president had a ready answer. A great university, Eliot wrote, “cannot be managed like a railroad or a cottonmill” precisely because he believed that such institutions of higher education should “spend every year all their income.”

This might seem like strange advice coming from a man hell-bent on building an endowment. But here, too, Eliot was on to something. Rather than try and run surpluses, as most universities did, or even creating “rainy day” funds to cover shortfalls, Eliot seems to have deliberately accumulated deficits.

To address them, he would pointedly refuse to raise tuition or fees, much less argue for cutbacks. The only solution, he argued to potential donors, was to generate more free money: “further endowment is the only thoroughly satisfactory and permanent remedy.” Of course, once he had the additional donations to close the annual deficit, he promptly increased spending, beginning the cycle anew.

Eliot’s plan went beyond just soliciting donations to the endowment. Rather, he believed that how the money was invested mattered, too. In his inaugural address in 1869, he argued against the conventional practice of putting the funds exclusively in solid but unspectacular investments such as mortgages and bonds.

“An institution like this College,” he declared, “is getting decrepit when it sits down contentedly on its mortgages. On its invested funds the Corporation should be always seeking how safely to make a quarter of a per cent more.”

Eventually, other elite universities adopted the Harvard model, and in recent years they have pushed the envelope on risky investments. Harvard’s investment arm, founded in 1974, is credited with revolutionizing the way universities managed their money, expanded beyond conventional bonds and stocks into assets such as hedge funds and private equity. Under Jack Meyer, the endowment's CEO from 1990 to 2005, assets grew to almost $26 billion from $4.7 billion.

More recently, however, Harvard has struggled. It posted a 27 percent investment loss in 2009 and was forced to sell assets and borrow money.

Were Eliot still alive, he might counsel more prudence. Then again, he would have seized on the news that Yale’s endowment had done better than Harvard’s, by drafting an urgent plea to alumni and donors soliciting donations to, yes, the endowment.

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To contact the author on this story:
Stephen Mihm at smihm1@bloomberg.net

To contact the editor on this story:
Max Berley at mberley@bloomberg.net