Published March 3, 2019

First of four parts

AUSTIN— It was a grand promise, one our forefathers made 165 years ago to all Texas children, to theirs and ours and those not yet born.

With $2 million and the state's most abundant and precious resource — its land — they created the Texas Permanent School Fund to forever support public education. It was called a "sacred trust."

That trust, dedicated to K-12 schools, is now valued at $44 billion, bigger than even Harvard University's endowment.

It is also broken.

The Permanent School Fund has failed to match the performance of peer endowments, missing out on as much as $12 billion in growth and amassing a risky asset allocation, a yearlong Houston Chronicle investigation reveals.

Outside fund managers have charged the endowment at least a billion dollars in fees during the past decade, records show. Some of them have had professional or personal relationships with Texas School Land Board members, who govern a portion of the fund.

And, critically, the fund is sending less money to schools than it did decades ago, in real dollars. The amount dropped to an average of $986 million annually over the past decade from an average of $1.14 billion in the previous 20 years, in inflation-adjusted dollars. Last year, the fund distributed only 2.8 percent of its value — roughly half the share paid out by many endowments.

That decline, coupled with a 2 million increase in the number of students over 30 years, has slashed the fund's per-student distribution.

Per student, the fund has paid an average of $207 annually over the past decade compared with $322, adjusted for inflation, over the prior two decades, a drop of more than one-third.

According to the Congressional Research Service, between 1998 and 2017, the average payout from higher education endowments has ranged between 4.2 percent and 5.1 percent. If the Texas fund paid out 5 percent of a four-year average market value, as many endowments try to, Texas schools would have received $720 million more in 2018.

The fund's decline is one piece of a bigger, critical problem, said Rep. Diego Bernal, D-San Antonio, vice chair of the House Committee on Public Education.

"That failure is not the failure of some nameless, faceless fund," he said. "It's the failure of previous Legislatures to make adjustments to make sure students are getting what they need."

Bernal said he's optimistic that's about to change.

Gov. Greg Abbott in February declared public school funding and property tax reform emergency items. Local taxpayers have seen their tax bills climb over the past decade. But the state's contribution has remained flat, now at 36 percent, according to the state comptroller. Enrollment growth and shrinking budgets have forced many school districts to cut, and cut again. Of the 10 largest school districts in the Houston area, all but three faced shortfalls of at least $1 million when they approved their budgets last summer, including the Houston Independent School District, which is projecting a shortfall for the coming year in the tens of millions of dollars.

RELATED: Read our entire series here

Rep. Travis Clardy, an East Texas Republican, said the state's public education funding system is "unrecognizable from where it started."

"Duct tape and Band-Aids and baling wire are holding it all together," he said. "We need to break it apart, get a clean slate, and come up with a funding mechanism for our public schools that will do what our Constitution requires us to do and fund it fully, fairly, equitably and freely for all the students of Texas."

The Chronicle investigation found that a series of changes since 2001 has fundamentally changed the way the fund invests and distributes money to schools.

The fund is now under the control of two secretive governing bodies — the State Board of Education and the School Land Board — that manage separate chunks of the portfolio but don't coordinate investments and never meet together.

The two boards have publicly sparred in recent months over how best to invest and distribute money, each claiming to have a superior strategy or higher returns.

SOLUTIONS: The Permanent School Fund is broken. Here's how it can be fixed

Holland Timmins, who administers the State Board of Education's $34 billion portion of the fund, said his board can't send more money to schools because the School Land Board isn't chipping in enough every year.

"That's the real volatility in our world," Timmins said.

George P. Bush, the elected Texas land commissioner and chairman of the School Land Board, said returns on its $10 billion share of the portfolio beat other major state investment funds, including Timmins', citing a report by the Legislative Budget Board, a panel of lawmakers that helps shape state spending.

Texas Land Commissioner George P. Bush

"We're at the top, perennially," Bush said.

The budget board's latest report on major state investment funds, from 2015, put the land board's 2015 annual return on its portfolio at 11 percent, the top of all state funds that year, compared with a 3 percent loss for the education board.

But the land board's internal records show it is performing far worse. The land board's returns did not account for the cost of fees or the drag of billions of dollars in low-interest cash in the state treasury — a fact contained in a footnote in the budget board report.

In fact, until the Chronicle began asking questions, citizens could not ascertain the land board's real returns. Its quarterly reports were labeled "highly confidential."

An early warning

Texas' founders created the school fund in 1854, using $2 million in bonds received as part of their payment from the U.S. government for giving up 67 million acres of land stretching from Wyoming to New Mexico.

Legislators later dedicated millions of acres of land to be sold and proceeds deposited into the fund, which would create a permanent source of revenue for education. Only the earnings would be spent, not the principal, to protect it for future generations.

But by 1883, Texas Gov. John Ireland was worried, and he warned in his inaugural address that the fund was being exploited by "the capitalists, the land hungry and greedy."

How the money flows The Permanent School Fund, an endowment established by the Texas Constitution, is a $44 billion fund fed by the state's oil and gas royalty revenue and its returns on investments. It is managed by two separate boards: The School Land Board, which controls $10 billion of the portfolio, collects the state's oil and gas royalty revenue and invests primarily in private equity. The land board has the option to send money to the education board to invest, or directly to the Available School Fund, which distributes the money to schools for textbooks and other expenses based on average daily attendance. The State Board of Education controls $34 billion of the portfolio, which includes stocks, bonds and alternative investments. The education board is tasked with deciding how much the endowment sends to the Available School Fund based on a complex formula that includes inflation, student growth and contributions from the land board.

"I think I see away down the corridors of time, this splendid territory teeming with millions," he said, "when some one of them will gather up the fragments of our history and realize ... how this generation had in its power and keeping a fund that should have gathered like a snowball as time rolled on."

Land funds across the country had failed, some in the South after Confederate war bonds collapsed. Many in the Midwest hung on until the Great Depression. Of the school funds that remain today, Texas' is by far the largest.

DENIED: Read about how Texas systematically denied thousands of children the education they deserve

Its salvation was oil.

In 1914, the fund received its first royalty, $33.97, from Goose Creek oil field in Harris County. Last year, the land and royalty income totaled more than $994.5 million.

With that kind of cash, the fund should be sending record amounts to Texas schools, said former Texas Land Commissioner Garry Mauro. For most of his tenure in the 1980s and 1990s, the school fund sent an average of about $370 per student, adjusted for inflation.

Mauro was shocked at the annual average of $207 per student during the past decade.

"What the (expletive) is wrong?" asked Mauro, a Democrat.

Huge spike in fees

For generations, the State Board of Education was constrained in how it could invest, permitted by law only to hold stocks and bonds. The School Land Board had even less leeway. It acted as a kind of land manager, collecting royalties and income and sending them passively along to the education board for investment.

The income generated from the investments paid for instructional materials and was doled out to districts for other expenses, such as teacher salaries, based on their average daily attendance.

But a series of laws and constitutional amendments between 2001 and 2011 vastly changed the operation of the fund. The School Land Board gained the power to retain and invest land income and oil and gas royalties and other revenues; the State Board of Education was required to decide how much money to send to schools each year instead of automatically passing along all investment income. The Legislature also lifted constraints on how both boards could invest.

There are limitations to how much the fund can send to schools. A key one: Distributions cannot exceed the total return on investments over a 10-year period.

The changes triggered a transformation of the Permanent School Fund. In 2006, the fund as a whole was relatively conservative, with about two-thirds of its investments in stocks, 20 percent in bonds, and the rest in state land and oil and gas rights. But over the next dozen years, the fund shifted its money into private equity and hedge funds — riskier fields with potentially higher returns. In 2018, it had more money in such "alternatives" — 38 percent — than any other asset class.

At the same time, the School Land Board was buying real estate. Between 2001 and 2007, the land board purchased thousands of acres of land for more than $536 million. It entered into secretive partnerships with major developers and private equity firms.

FUNDING: Abbott's tax break for homeowners would sap billions in school funding

The consequence: a riskier set of assets, less transparency, and much higher management fees. The private equity firms, for instance, charge a flat fee annually, plus a cut — often 20 percent — of the profits.

The Chronicle tried for a year to get a full accounting of fees and expenses for the fund. The education board insisted it did not track the cut of profits taken by fund managers, but later said it started doing so in late 2017. The land board insisted it could only provide its fees on a calendar year basis, making it impossible to compare with what is reported to the Legislature, which is on a fiscal year basis ending each Aug. 31.

By any measure, fees have increased sharply. The land board's rose from $14 million in 2008 to $92 million in 2017, including carried interest. The education board's rose from $14 million in 2008 to $101 million in 2017, though it's unclear what fees are included in that total.

"Good gracious," said Buck Wood, a lawyer who specializes in school finance, after hearing how much the fund pays in fees. "That means it's not nearly as profitable as you'd think it would be because you're paying so much more in fees."

The Texas fund is hardly alone in facing hefty fees for money management. Yale in particular has fielded criticism for how much it pays. Its justification: high returns. In 2018, Yale earned 12.3 percent on its investments after accounting for fees.

Poor performance

During the past 20 years, U.S. funds similar in size, structure or mission grew faster than the Texas school fund and paid out a higher percentage of their value. A comparison of the funds, using figures adjusted for inflation, shows:

• The New Mexico Land Grant Permanent Fund, an endowment fed by oil and gas that donates to the state's public schools, among other things, has grown by 81 percent, from $9.9 billion in 1998 to $17.9 billion last year. Over the same period, it boosted annual distributions to schools by 76 percent, from $392 million to $689 million — about 3.9 percent of its market value.

• The Yale University fund, one of the top-performing endowments in the country, jumped by almost 191 percent, from $10.1 billion to $29.4 billion last year. And the amount it sent to school operations annually almost quadrupled, soaring from $334 million to $1.28 billion, or about 4.4 percent of its fund.

• The Permanent School Fund's sister endowment, the Texas Permanent University Fund, which invests oil-and-gas revenues collected on land owned by the university system, has swollen by 118 percent, from $10 billion to $21.9 billion. Meanwhile, its annual distributions rose by 122 percent, from $400 million to $887 million, about 4.1 percent of its worth.

• But the Texas Permanent School Fund grew around 76 percent over the two decades, from $25 billion to $44 billion last year. And its distributions to schools rose in real dollars by a little over 16 percent, from $1.061 billion to $1.235 billion — tumbling from 4.2 percent of its market value in 1998 to 2.8 percent in 2018.

SOLUTIONS: The Permanent School Fund is broken. Here's how it can be fixed.

One way to look at a fund's performance is by its growth in market value. Another way is to examine its returns.

Analysts at Markov Processes International, a global investment research and technology firm, estimated that the fund was performing comparable to the worst-performing Ivy League endowments. One hundred dollars invested in the top-performing Ivy League endowments about a decade ago would be worth roughly $250 now. The Ivy average came in at about $220. The same cash put in the Permanent School Fund would now be valued at about $190.

And Jeffrey Hooke, a 30-year veteran of private finance who now researches pension funds and endowments at Johns Hopkins' Carey Business School in Baltimore, said the Texas School Fund wasn't even coming close to the performance of a common index fund of 60 percent stocks and 40 percent bonds. Over 10 years, ending August 2017, one such index fund had returns of 6.86 percent annually, which beat the fund's performance, as Hooke and his colleagues estimated it, by almost 2 percentage points a year.

That may sound like peanuts, Hooke said. But a 2 percentage point increase in the growth of the Permanent School Fund every year for the past decade would have added $9 billion to the endowment's coffers.

Tom Maynard, who chairs an education board subcommittee, said the board's distributions are constrained by a complex formula designed to strike a balance between funding schools today and growing the fund.

"If you overspend today, you are going to shortchange the future generations," he said.

Misleading public reports

The fund's slip into mediocrity has happened almost entirely out of sight of the public, which knows little about it, and out of the watch of state politicians, who generally think that because the fund is growing, it's doing well.

Sen. Kirk Watson, D-Austin, questioned Bush at a legislative hearing in November, asking him for a justification for having the two boards managing the fund.

"Getting a higher return," Bush said, citing the Legislative Budget Board's 2015 report that put the land board's 2015 returns at about 11 percent, at the top of Texas funds.

Governor Greg Abbott

The land board's returns are in reality about half of what the budget board reported. Internal quarterly reports from the same time — the ones stamped "Confidential" — put the 2015 returns at 4.88 percent, accounting for fees and the lower return on cash deposits.

Bush told the Chronicle after a Land Board meeting that the board is restricted by the Legislature in how it can invest.

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"We invest purely in real assets — commercial real estate, oil and gas and infrastructure — so while we wait for them to call capital, the cash is at the treasury getting 2 percent," Bush said, "so it affects the return profile."

The board's latest quarterly investment report puts its annual return on investment at 3.8 percent since 2006, after factoring in fees and cash.

The State Board of Education, for its part, insists it outperforms the land board, though it says it doesn't track all earnings of its external fund managers.

Moreover, the two agencies report their returns in the fund's annual report separately and before deducting fees, making it difficult for the public to know how well the fund is performing overall.

There is no singular governing body responsible for oversight of the fund, which has led to infighting over which board gets to invest the oil and gas money.

Usually, the School Land Board sends a couple of hundred million dollars a year to the State Board of Education for investment. In 2018, for the first time, the land board decided to send money — some $300 million in each of 2019 and 2020 — directly to schools without giving any to the education board to invest. After publicly bickering over the decision, the land board later decided to send an additional $55 million to the education board.

The School Land Board is collecting nearly a billion dollars a year in revenue, said David Bradley, a Beaumont Republican who served on the state education board for 22 years.

"And they have no requirement to distribute it," he said. "Why are they doing that? I don't know. They're empire building."

HOW WE DID IT: Read how the Chronicle reported this story here

Watson said the fund's divided management structure has created "a very serious governance issue."

Bernal, who sits on the House education committee, said the "strange turf war" between the two boards is distracting from the bigger issue.

"No one is really saying what's in the best interest of the kids," he said.

Ireland, the former Texas governor, rallied legislators 136 years ago to protect the school fund from steep fees charged on its investments.

"Shall we guard and increase and protect this fund as a sacred trust?" Ireland asked then.

"Or shall we throw it away?"

Data editor Matt Dempsey contributed to this story.

Part 2: Friends get benefits

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Susan Carroll joined the Chronicle in 2006 and works as an investigative/projects reporter. She was part of the team that was a finalist for the Pulitzer Prize for breaking news for coverage of Hurricane Harvey. Along with colleagues Matt Dempsey and Mark Collette, her 2016 work on the danger posed by chemical plants in southeast Texas won awards from the National Press Foundation and Investigative Reporters and Editors. Carroll previously covered the U.S.-Mexico border for the Arizona Republic and the Tucson Citizen. She can be reached by e-mail at Susan.Carroll@chron.com or by Twitter: @_SusanCarroll

David Hunn came to the Chronicle in 2016 as an enterprise reporter covering energy. He wrote about bankruptcies and debt loads after the 2014 oil price crash and the boom in the Permian Basin that followed. He was part of the team that was a finalist for the Pulitzer Prize for breaking news for coverage of Hurricane Harvey. He previously worked at the St. Louis Post-Dispatch, where he was on a team that was a finalist for a Pulitzer Prize for coverage of a city hall shooting. He recently returned to the Post-Dispatch and can be reached by Twitter: @davidhunn

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