Legal challenge could 'devastate' UT, A&M projects, letter claimed

By: R.G. RATCLIFFE
Houston Chronicle Austin Bureau
October 31, 1999, Sunday

AUSTIN - University of Texas officials have invested almost $450 million with private investment bankers even though they knew a potential constitutional challenge to the bankers' fees could "devastate" construction financing at UT and Texas A&M, indicates a letter obtained by the Houston Chronicle.

A draft state audit in 1996 questioned whether UT and its financial manager, the University of Texas Investment Management Co., UTIMCO, were violating state constitutional limits by paying private partnership management fees from the Permanent University Fund.

The auditors contended the management fees should be paid from another fund, the Available University Fund. They said an attorney general's opinion should be requested to straighten out the matter.

But UT Chancellor William Cunningham, in a sternly worded letter at the time, warned that even to request such an opinion would seriously damage construction programs at UT and A&M.

While the 1996 draft audit was leaked to the public more than two years ago, UT and UTIMCO have repeatedly turned down news media requests for a copy of Cunningham's letter to auditors. UT officials have steadfastly maintained that the letter only argued that auditors should drop the issue on legal points.

But while Cunningham argued the legal points in the letter, the clear emphasis was that if auditors pursued the constitutional question they would be responsible for shutting down university construction projects.

The end result, he said, would be to risk the credit rating of bonds issued by the Permanent University Fund.

The PUF was constitutionally created in 1876 and is primarily funded by oil and gas royalties. The Available University Fund is derived from the interest and earnings of the PUF and is used to underwrite university construction. The AUF gets about $260 million a year from the permanent fund.

Cunningham said federal securities laws would require the university to disclose to potential bond purchasers that a change in how management fees are paid to private partnerships would drain $233 million from the Available University Fund over 10 years.

That liability would "devastate the Available University Fund and thereby severely damage both the PUF bond financing program and the scholarship and other excellence programs," Cunningham wrote.

"The (state auditor's) recommendation, if published, will have the unintended consequence of placing the credit ratings of approximately $1 billion of PUF bonds at the risk of a severe downgrading and the suspension of the issuance of additional PUF bonds," the chancellor's letter said.

Cunningham last week said auditors dropped the issue because he convinced them that UT's method of accounting and paying private investment managers was constitutional.

"The auditors raise issues and you respond to the auditors," Cunningham said. "In this case, the auditors have dropped the issue and we've gone on to other things."

State auditors earlier this year told the Chronicle that they dropped the issue after UT assured them that they had an opinion from the law firm of Vinson & Elkins supporting the constitutionality of the UT investment program.

In an October 1996 memo to University of Texas Investment Management Co. board members, UTIMCO President Tom Ricks said the auditors' question "is further evidence that the constitutional provisions governing the PUF are incompatible with modern investment theory and practice."

A constitutional amendment on Tuesday's ballot, Proposition 17, would cure the constitutional conflict if voters approve it. The measure would change the way PUF investments are managed and remove many of the current constitution's restrictions on the fund.

UT and A&M supporters have been selling Proposition 17 as a method of modernizing university investments to make about $50 million a year more available to higher education spending by 2004.

Failure of the amendment would deny the universities a more flexible investment fund and additional available income. It also would leave the PUF private investment program without a final resolution on whether its private equity program is operating constitutionally.

The constitution requires that all capital gains of the PUF be returned to the fund, while interest earnings less expenses are transferred to the Available University Fund for spending.

In a limited partnership, the general partner normally gets a management fee of 1 percent of the investment each year plus 20 percent of the profits when the investment is closed out after a seven- to 10-year period.

But the state auditors said the profits of a limited partnership could be considered a capital gain that would require the fees to be paid from AUF money instead of the PUF.

"Although (UTIMCO) management has indicated that this is purely an accounting issue, we believe that the structure of the Permanent University Fund set forth in the constitution introduces sufficient legal complexities to warrant a review by the attorney general's office," auditors said in the 1996 draft report.

"If the current treatment of fees is unconstitutional, the (UT Board of Regents) should re-evaluate the appropriateness of private investments for the Permanent University Fund due to the potential impact on the Available University Fund," the auditors said.

At the time of this behind-the-scenes controversy, the PUF had about $372 million invested with private limited partnerships.

UTIMCO has more than $1.7 billion committed to private partnership investments in total, but investments made from the university's endowment funds are not subject to the same constitutional restrictions as the PUF.

The Chronicle reported earlier this year that almost a third of UTIMCO's private equity investing had been made with managers who were either business associates of former UTIMCO Chairman Tom Hicks or major Republican political donors.