PE gets schooled

The tax reform law hits these institutional investors and could lead to long-term consequences.

University endowments weren’t spared in the US tax reform enacted in December.

They have traditionally been tax-exempt but no longer. The letter of the law still needs to be defined, but in its current form, the 1.4 percent on net endowment income will target all private college endowments that are larger than $500,000 per full-time student and that enroll more than 500 students.

This will affect more than 30 organisations, including some of the most prominent private market investors such as Princeton, Yale, Harvard and Stanford. Harvard’s $37 billion endowment, for example, would have had to pay $43 million last year if the tax legislation had been in place.

Samuel Brunson, a tax law professor at Loyola University, suggests that endowments could have an incentive to shift a small portion of their investments to more liquid assets to make sure they have easy access to cash to pay the tax. He also thinks endowments could start requesting annual distributions from private equity funds in side letters to meet the cost.

Harvard Business School Professor Luis Viceira noted in a The Harvard Crimson article on 2 February that the precedent could lead to longer-term consequences.

“Once you have started taxing returns on the endowment, the tax rate could go up,”  Viceira says. “And if it does, it can start having a meaningful impact on how Harvard will think about investing.”

He adds if the rate increases – up to 10 percent, for instance – the university will have “preference for securities that are tax-efficient”. Harvard Management Company would look for longer-term capital gains such as equities rather than short-term dividends such as fixed income investments.

College and university leaders criticised the tax in a letter to Congress, in which they said they fear the tax will limit endowments’ ability to contribute to financial aid and scholarships.

“The net investment income tax will impede our efforts to help students, improve education, expand the boundaries of knowledge, advance technological innovation, enhance health and well-being,” they wrote. “Each year we spend funds from our endowments to support this critical work. Endowments are not kept in reserve to be drawn on only occasionally or on a rainy day.”

But this focus on endowments’ work has drawn attention to private equity fees. Several recent news reports have pointed to a 2015 op-ed in The New York Times by University of San Diego Law Professor Victor Fleischer, who wrote that many large endowments spend more on their private equity fund managers than on their students.

THEORY V REALITY

“In theory, it’s a valid point,” Brunson says. “It does in fact reduce the amount they have available. But if they’re acting like private investment firms, just accumulating money, then it’s a little less compelling. They’re effectively just a hedge fund and they get the tax exemption because they’re associated with a university.”

Taxing endowments based on how much (or little) they spend on educational purposes instead of based on their size makes much more sense, he argues, and would alleviate some of the criticism of the type outlined by the NYT. It may, however, result in fewer endowment dollars flowing into PE.