Endowment Spending Under a Liquidity Stress Test
You advise a $300 million endowment with a 4.5% spending rule based on the three-year average market value, an inflation assumption of 2.5%, and investment costs of 0.6%. The current policy portfolio is 60% global equity, 30% investment-grade bonds, and 10% cash; its expected nominal return is 6.4% with volatility of 11%. Annual spending is $13.5 million, and gifts are expected to be $3 million. The board proposes adding a 20% private equity allocation, funded from equities and bonds, with an expected return of 9.5%, a 10-year lock, and capital calls of 18% of committed capital in each of the first three years. The endowment also guarantees a $25 million letter of credit for a campus project, collateralized by liquid assets. Policy requires at least 25% of assets in daily-liquid securities. The board wants to maintain real spending per unit.
1. Calculate the required nominal return to preserve purchasing power after spending and costs. Compare it with the current expected return.
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The required return before costs is (1.045 × 1.025) − 1 = 7.11%. Adding 0.6% investment costs gives 7.71%. Gifts of $3 million are 1.0% of $300 million, so the investment return needed falls to about 6.71%. The current expected return is 6.4%, a shortfall of about 31 bp even with gifts, and 131 bp without gifts. The board's goal of maintaining real spending is therefore not supported by the current policy portfolio unless returns exceed assumptions, spending is cut, or gifts rise. The calculation should be shown on a compounded, not simply additive, basis.
2. Assess whether the 20% private equity allocation is consistent with the spending and liquidity policy. Include capital calls and the letter of credit.
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A 20% PE allocation is $60 million. If funded from equities, equity falls from $180 million to $120 million and PE rises to $60 million, leaving bonds $90 million and cash $30 million. Daily-liquid assets are bonds plus cash = $120 million, or 40%, and free liquidity after the $25 million letter of credit is $95 million, still above the $75 million policy floor. If funded from bonds or cash, liquid assets fall to $60 million and free liquidity to $35 million, a clear breach. Capital calls are 18% × 60 = $10.8 million per year for three years. Cash of $30 million plus $3 million gifts minus $13.5 million spending gives a net cash drain of $21.3 million per year including calls, so the cash buffer lasts only about 1.4 years. The allocation is feasible only if calls are met from equity sales or a standby facility.
3. Recommend an implementation path that preserves the 25% liquidity floor and the spending rule.
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Fund PE from equities, not from bonds or cash, and cap the initial allocation at 10-15% until the capital-call schedule is proven. Hold at least 12-18 months of net cash outflows, including spending less gifts plus expected calls, and arrange a standby credit line sized to one year of calls. Set rebalancing bands and a policy that suspends new commitments if liquid assets fall below 30% or if the letter of credit is drawn. Stress test a 30% equity drawdown: equity would fall to about $126 million and total assets to $246 million, while liquid assets remain $120 million and free liquidity $95 million, above 25% of the stressed total. If calls accelerate or spending is based on a lagged average, the board should reduce PE to 10% rather than rely on forced sales.