We are all familiar with the notion of a bath in our communal lives, but the term “big bath” is equally common in the corporate world. Big Bath is an earnings management technique whereby a one-time charge is taken against income in order to reduce the value of an assets. This technique is often employed in a bad year, e.g., when sales are down, or when a company reports losses, to account for overvalued assets on the balance sheet.
Although the process is discouraged by auditors, it is frequently used by public companies. A notable feature surrounding big baths is that this accounting treatment tends to coincide with new management team because the new management team can then blame the one-time charges on the prior management team while simultaneously calibrating current reported income to unusually low levels thereby making it easier to meet or beat income in future periods.
Big Bath in Non-profit Sector
Does Big Bath happen in the non-profit sector? Bien sûr!
Harvard University has the largest endowment fund in the world with assets around $37 billion. The new chief of Harvard University’s endowment, Narv Narvekar, actively pushed to slash the value of some of its investments in natural resources portfolio of forests, farms and vineyards given his bearish outlook on some of the assets. Although Harvard University has the largest endowment, it was the only Ivy League endowment which generated less than 10% in the most recent year, which is why there was a “change of guards” at fund management level.
New endowment chiefs often have an incentive to write down investments they inherit because it is easier to blame the losses to the prior investment chief. It also helps remove potentially overvalued assets. Mr. Narvekar described Harvard Management Co. as having “deep structural problems” that would take five years to restructure. “An honest, reflective, and clear-sighted recognition of these problems is the first critical step towards generating solutions,” he wrote in his first annual letter in September, 2017.
Under Mr. Narvekar, Harvard reduced the value of its natural-resources investments by more than 25%, which is an unprecedented amount of a write-down (Harvard had valued the portfolio at roughly $4 billion at the end of the prior fiscal year).
Big Subjective Decisions
Many asset managers and appraisers say valuing assets that trade infrequently or aren’t generating cash—trees, for example, take years to grow before they can be sold for timber—is difficult. However, the new chief investment officer indicated that some natural-resources investments carried more risk than previously calculated. Therefore, he raise the discount rate (because the risk was high), which caused some investments to lose value.
Valuations for the endowment’s private assets were approved by the board, reviewed by Harvard and “the valuation process was independently verified by external auditors,” board Chairman said in a statement.
Big Pay Day
Harvard has guaranteed Mr. Narvekar at least $6 million a year for his first three years on the job. Additionally, the Chief is expected to earn additional performance-based compensation which is expected to be closely tied to the endowment’s performance in the long term.
When a non-profit sector mimics the pay of the for-profit sector in order to generate high future returns on the largest endowment fund!
January 25, 2018by