Daniel Connolly, USA TODAY NETWORK – Tennessee
Note: The Paradise Papers project from the International Consortium of Investigative Journalists highlighted financial transactions in secretive jurisdictions including the Cayman Islands, located in the Caribbean south of Cuba.
Leaked documents were obtained by German newspaper Süddeutsche Zeitung and shared with the ICIJ, which organized the global collaboration. This article is part of the ICIJ’s Alma Mater project, an expanded review of university endowments placing money offshore.
The University of Tennessee’s endowment has pumped millions of dollars into private investment funds in recent years, including many chartered in the Cayman Islands.
And the university successfully lobbied the Tennessee legislature to pass a law last year that keeps the details of these and other “alternative investments” secret.
Under the new law, the university still must disclose basics such as the name of the fund and the amount of money in it. But it doesn’t have to disclose the fees the managers charge, or the specific companies in which the funds are invested, unless the managers agree.
“I think as a public university that relies partly on taxpayer money and donor money that is being funneled to these managers, I think that’s just unacceptable,” said Thomas Gilbert, a finance professor at the University of Washington in Seattle who studies endowments.
“There are managers who won’t work with people that don’t have these (rules) in place,” Mecherle said. “And as you can imagine, if the managers can afford to be choosy, they’re probably pretty good.”
Gilbert says managers fear they’ll lose business if the public knows the high fees they charge. He imagines managers telling institutions like UT that they’ll deliver the “awesomest” performance.
The secrecy law and the university’s investments in funds based in the Cayman Islands reflect broader trends.
Alumni donations go into university endowments, which are invested.
University endowments previously put most of their money into publicly traded stocks and bonds. But they’re now spending heavily on private equity, hedge funds and other items dubbed “alternative investments,” some of which are based in the Cayman Islands.
It’s unclear if that approach will work in the long run, and the decision could affect a lot of people. UT routinely uses endowment earnings to help support the university’s 49,000 undergraduate and graduate students statewide, plus its staff of about 12,000.
Why universities route money to the Cayman Islands
For instance, a university that runs a gym for physical education classes and charges other people for membership might have to pay UBIT taxes on the membership fees, since the income is unrelated to its core mission of educating students.
Certain endowment investments might be subject to UBIT. Cayman Islands investments known as “blockers” prevent the university from having to pay UBIT taxes.
Tennessee collects an excise tax on nonprofits’ unrelated business income that works much the same as federal UBIT.
“Because obviously, if we can legally use a structure of a fund that will lower the tax bill and increase our investment yield, we want to do it,” he said.
A shift to alternative strategies
In the past, university endowments invested mainly in stocks and bonds.
But the proportion of endowment money in alternative strategies such as hedge funds has jumped dramatically, from 20 percent in 2002 to 52 percent in 2017, according to a Congressional Research Service report.
As of June 2017, the UT system’s total investment in private equity funds and what it calls alternative strategies — mostly hedge funds — equaled roughly $345 million, about 38 percent of all investments.
That doesn’t include other items sometimes considered alternative investments, such as natural resources funds.
That $345 million number includes at least $199.3 million in the Cayman Islands and other offshore settings. Those offshore investments represent about one in every five dollars in the endowment.
A committee approved the decisions with guidance from Mecherle and representatives from Cincinnati-based financial adviser Fund Evaluation Group.
Mecherle says the university sought to take advantage of opportunities in private markets.
But critics point to a risk: Unlike stocks and bonds that are easily traded, many of these investment funds are hard to sell, particularly in hard times.
Mecherle says UT watches this carefully and that the benefits outweigh the risks. For instance, private, hard-to-sell funds face less pressure to sell assets in a down market and provide access to markets that are normally off-limits, he said.
Higher fees at hedge funds
Gilbert, the finance professor, says managers of hedge funds, private equity and other alternative investment funds charge big fees.
For instance, a simple stock index fund might charge a fee of just .05 percent of all assets under management. A stock fund with active buying and selling might charge a full 1 percent.
Hedge funds often charge “2 and 20” — 2 percent of assets under management, plus 20 percent of gains.
Gilbert says research shows funds like this don’t beat the market. One famous test was the “Buffet bet,” in which investor Warren Buffet bet $1 million that an index fund would beat hedge funds over 10 years. Buffet won.
“It’s millions of dollars, millions of dollars going out the door for performance that’s not any better,” Gilbert said.
Mecherle, the UT official, says good private managers do outperform the market. “The challenge is finding the good ones, the same as any other investment category,” he wrote in an email. Hedge funds are also designed to do well in many different environments, not just an “up” market, he said.
He also said today’s hedge funds often charge less than the “2 and 20” model. And hedge funds must prove they outperform benchmarks.
Investment committee member George Cates says the board members have worked to keep fees low. “We are hawks that we not pay big fees, as you may imagine.”
Mecherle declined to release a schedule of fees.
The secrecy law
Mecherle said about three years ago, the university received open records act requests about private funds.
He believes at least one was filed by a finance person seeking competitive advantage. The outside fund managers didn’t want him to release the information.
Mecherle said he learned that the state retirement system already has restrictions on the release of such information. “I said, ‘Well, we need something like that too.'”
The new law restricting information was signed by the governor on May 4, 2017.
Rachel Ohm with the Knoxville News Sentinel contributed to this story.
Questions and answers
Are these offshore funds legal?
Yes, everything described in this article is legal.
What is an endowment?
When donors give to a university, the money often goes into endowment funds dedicated for specific purposes.
The University of Tennessee has various endowments, ranging from the Kenneth Curry Library Endowment to the Clarence and Marian Brown Theatre Endowment. These thousands of different funds are merged together in what’s called the Consolidated Investment Pool. That big pool is worth around $1 billion.
The university uses earnings from the big endowment pool to pay for professorships, scholarships and other expenses on campus.
How much does the University of Tennessee use from the endowment each year?
Typically it’s 4.5 percent of the funds in the endowment. In 2017, it was $39.2 million, about 2 percent of UT’s operating expenses of $2.1 billion.
You said the endowment is investing in “alternative investments.” What does that mean?
“Alternative investments” refers to several types of investments that aren’t stocks or bonds. Here are some common types:
- Private equity: Private equity funds typically buy stakes in private companies, or buy public companies and take them private. Private equity funds typically try to recover their money in four to seven years, according to the financial education web site Investopedia.
- Hedge funds: Hedge funds are investment funds that pursue a wide range of strategies. Because hedge funds face few regulations, they are usually available only to institutions or wealthy individuals.
- Venture capital: Venture capitalists invest directly in promising new companies in the hopes that they’ll make it big.
The phrase “alternative investments” can also refer to other investments such as real estate, energy and natural resources.
Why did universities start boosting the use of alternative investments?
The success of Yale University’s current investment manager David F. Swensen has influenced universities across the country to buy these investments in the hopes of better returns.
As The New York Times put it, “(Swensen) has pioneered an investment strategy that expanded Yale’s portfolio from a plain-vanilla mix of stocks and bonds to substantial holdings in real estate, private equity and venture capital, along with other alternatives. Until then, the typical endowment was far more conservative.”
Why is the use of alternative investments controversial?
Critics argue they often charge big fees and don’t deliver better results than cheaper stock and bond funds.
They also present a different type of risk. A university can easily sell stock and bond funds, while private equity, hedge funds and other alternative investments are “illiquid” — that is, much harder to sell in a hurry.
Supporters of this approach say that properly managed, the benefits from alternative investments outweigh the cost.
Are all alternative investment funds based in the Cayman Islands?
No. Many of them are based in the U.S.
Why would universities invest in alternative investment funds based in the Cayman Islands?
One major reason is to avoid having to pay a type of taxes known as Unrelated Business Income Tax, or UBIT.
Nonprofits have to pay the tax on businesses that are not related to their core mission — for instance, a university charging community members to use a gym.
Some funds based in the Cayman Islands are set up as “blocker” funds that shield institutions from having to pay UBIT and related taxes.
Who makes the decisions over the University of Tennessee’s endowment investments?
Rip Mecherle is the university’s chief investment officer. He and advisory company Fund Evaluation Group present investment possibilities to the university’s Investment Advisory Committee.
As of this spring, members of the committee included UT Treasurer Ron Maples; Jim Haslam II, founder of the Pilot convenience store chain and father of Tennessee Gov. Bill Haslam; and several other university officials and outside supporters.
The makeup of the committee is changing. For instance, longtime member George Cates said his term ends this summer.
Which specific offshore funds has UT invested in?
This is a list of UT’s offshore investments and their market or appraisal value as of June 2017, according to the university treasurer’s office. All these funds are based in the Cayman Islands unless otherwise marked. This list does not include some other funds for which it was unclear where the fund was chartered.
- AQR Delta XN Offshore Fund, L.P. $18.8 million.
- Claren Road Credit Fund, LTD Class A, $1.1 million.
- Eton Park Overseas Fund LTD, $3.9 million.
- Gramercy Distressed Opportunity Fund III L.P., $8.7 million.
- GSO Special Situations Overseas Fund LTD Class-32-A, S-32, $277,000.
- HBK Multi Strategy Offshore FD LTD Class A SUBCL A Ser 1, $19.2 million.
- Indaba Capital Partners (Cayman) L.P., $18.8 million.
- Indus Asia Pacific Fund LTD Class A Series 1, $11.8 million.
- Palo Alto Heathcare Offshore II Cl C Ser Benchmark Jul 2008, $21.2 million.
- Pointer Offshore LTD AE-1-Series One, $18.3 million.
- Rimrock Low Volatility (QP) (Cayman) Fund, LTD. Class A, $12.7 million.
- Strategic Value Restructuring Fund Series G4 Sub M-Feb 13, $20 million.
- Taconic Opportunity Offshore Fund Class A-NR Series 1, $10 million.
- Taconic Opportunity Offshore Fund Ltd. Class B-NR-Series 3, $3.4 million.
- Graham Global Invest II SPC Tactical Trend Capped Beta, $18.8 million. (British Virgin Islands)
- Capital International Private Equity Fund VI, L.P., $3.9 million.
- Coller International Partners V-A. L.P., $1.6 million.
- Coller International Partners VI Feeder Fund, $5.9 million.
- Coller International Partners VII Feeder Fund, $756,000. (Guernsey)