Top US Universities' Endowment Fund In Deep Trouble

Article from NYT:

Steep investment losses have caused painful cutbacks at some of the best-known universities over the most recent fiscal year and have prompted questions about whether their endowments are taking too much risk. But as the schools, one by one, disclose their numbers, the managers of these endowments are indicating their continued support for a diversified portfolio chock full of alternative investments like hedge funds, private equity and real estate — the very things that have caused so much trouble.

This portfolio strategy is sometimes called the Swensen model, after David F. Swensen, who heads the Yale endowment. On last Tuesday, Yale disclosed the details of its year, reporting an investment loss of 24.6 percent, compared with an average drop of 17.2 percent for large funds, according to the Wilshire Trust Universe Comparison Service. The fiscal year for all major university endowments ended on June 30.

Preferring to emphasize their long-term results, the chiefs of many big endowments, including Harvard, Yale and M.I.T., have indicated they are sticking with their models. Notably, Mr. Swensen did not lay out Yale’s asset allocation for the coming year in his statement — something he has done in years past. Yale pointed out that even after its latest loss, it has produced an average annualized gain of 11.8 percent over the last 10 years. According to Wilshire, the average return during that period was 4.3 percent for endowments with more than $1 billion in assets. Just how unhappy fiduciaries are with the returns last year depends on whether they are focusing on one-year returns or 10-year returns.

A number of institutions will be looking for ways to avoid some of last year’s biggest headaches, like not having enough cash on hand to meet capital calls, as required under their contracts with private equity and similar funds. Harvard, which was down 27.3 percent last year, has acknowledged it suffered a cash squeeze and has since raised its portion in cash, among other measures.

“In most cases they will make small changes in the allocation to various categories,” said Byron Wien, vice chairman of Blackstone Advisory Services. “People are gradualists.” Along with holding more cash, Mr. Wien says he believes that endowments need to have more funds in emerging markets and in the credit markets as growth slows in the western world.

The biggest endowments seem to have stumbled the most in percentage terms last year. Doing better than either Harvard or Yale, the Massachusetts Institute of Technology said that its fund fell a more modest 17 percent and that its diversification strategy of embracing alternative investments had indeed cushioned its portfolio, a third the size of Harvard’s, against the market swoon.

By contrast, Yale said that diversification had failed to protect its asset values. The biggest drag on its performance was a 34 percent decline in its largest asset class, known as real assets, which include real estate, commodities and timber. Over all, the Yale fund fell to $16.3 billion at the end of June. That decline included a $5.6 billion loss from investments, $1.2 billion that was applied to the university’s budget and $200 million in new gifts.

Some big schools remain skeptical about the push for alternative investments. TheUniversity of Pennsylvania did relatively well in an abysmal year, reporting a drop of 15.7 percent, and did not have a lot invested in private equity, real estate and natural resources. The school’s endowment chief, Kristin Gilbertson, said that she had been slow to get into private equity and real estate after she took over in 2004 because she worried that the size of private equity funds was too large and their fees too high. Over a five-year period, Penn had an average annualized return of 3.5 percent. That compares with 8.7 percent at Yale. Still, Ms. Gilbertson says she is in a better position for growth now, partly because the fund has avoided some of the problems that will continue as a result of private equity deals struck from 2005 through 2007.

p/s photo: Zhou Wei Tong

Yale University Endowment Fund Beats Harvard

University endowment funds are widely tracked and followed. Yale, Harvard, Virginia, etc... have high profile managers and there is a strong fascination to follow how these supposedly top business universities manage their own funds. The fact that these universities can attract the best professors and teaches the best management practices and finance courses, puts additional pressure on themselves in that regard. Can they apply what they supposedly know best?

Yale and Harvard led the pack, and their most significant move was to diversify their portfolio into private equity and hedge funds. Harvard went as far as buying tracts of timber concessions. The rationale is quite good. If all your funds are in equity, you are tracking listed companies' fortunes. The best you can do is to continually beating the index, which is very difficult over the longer term. It can be argued that funds that seek out alpha returns are usually hedge funds and private equity funds, owing to the fact that they have specialised knowledge. The key is of course, being able to pick the right managers in private equity and hedge funds.

Even so, one can argue that these investments have a similar danger: they all tend to look good during a bull run, and not sufficient clarity is available on how they perform during extended bear markets like the ones you have currently. The danger is more pronounced in hedge funds because many hedge funds tend to close shop when they have a couple of negative years (not worthwhile to stick around, as you need to claw back the losses before you get your 20% profits on gains).

Endowment funds are not like other funds in that there is no "massive withdrawal by investors" or panicked runs on funds. In that sense, they are better off in holding out till the markets return. They only need to budget for annual fund requirements by the university to fund their operations. Nevertheless the article in portfolio.com did a good job singing the praises of David Swensen.

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University endowment managers followed Yale investment guru David Swensen into private equity and hedge funds, eager for the same 16 percent annual returns he got. Now with the crash, they’re short on cash. Luckily for Yale, Swensen didn’t always follow his own advice.Swensen’s idea, implemented at Yale and copied nationwide, was that universities should shift their endowment money out of traditional investments such as stocks and bonds and into higher-yielding ones like private equity, hedge funds, and real estate. The Yale model, as it came to be known, perennially outperformed stodgier strategies, gaining Swensen gurulike adulation. Since June, though, endowments on average have given up 22.5 percent of their value. Moreover, the economic crisis would seem to have exposed a major flaw in the Yale model: Alternative investments like private equity and real estate are very difficult to convert to cash without significant loss, leaving universities with a dearth of ready money. As a result, many schools have slashed operating budgets and sold off stocks at depressed values.

Swensen is unrepentant. Walking me through his offices on the fifth floor of a brick building a couple of blocks from campus, he shows me a slip of paper documenting the Yale endowment’s performance in the decade ending June 30, 2008: up 16.3 percent annually, compared with 6.5 percent for the average college endowment and 2.9 percent for Standard & Poor’s 500-stock index. The value added to Yale’s coffers was $14.9 billion.

Since Swensen took over in 1985, Yale’s endowment has led all universities in average returns and leapfrogged Princeton and the University of Texas to become the second largest, behind Harvard. In the spring of 2008, alumni mounted a campaign to name a new residential college after him. His insights into the markets landed him a spot on President Barack Obama’s economic-recovery advisory board.

Tributes clutter the walls and shelves of Swensen’s office: a 2006 fan letter from Warren Buffett (“Yale and the investment world owe you a great deal”); the Mory’s Cup for distinguished service to Yale, an award whose other recipients include former president George H.W. Bush (“Bush one, not Bush two,” Swensen notes); and a limerick in his honor by the economist and Nobel laureate James Tobin, celebrating the endowment’s reaching $10 billion in 2000. Called “Son of Sven,” it neatly summarizes the biography of Swensen, a Wisconsin native with a doctorate in economics from Yale: “A young Viking, a badger called Dave / Determined poor Eli to save / First he’d be / A PhD / And then make those markets behave.” Mugs illustrated by the children’s book author Sandra Boynton commemorate several endowment milestones: “I actually drink out of the $6 billion coffee mug every morning,” Swensen says.

He earned these plaudits with a bold strategy that increased Yale’s stake in private equity from 3.2 to 20.2 percent; in real assets—timber, real estate, and the like—from 8.5 to 29.3 percent; and in hedge funds, from zero to 25.1 percent. During his tenure, the share of Yale’s endowment invested in domestic stocks and bonds has dropped from 71.9 to 14.1 percent.

In his 2000 book, Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment, and in numerous speeches, Swensen championed such alternative investments. He argued that while beating the stock market is almost impossible because so much information is available about public companies and shares are accurately priced, shrewd managers can exploit inefficiencies in the pricing of less familiar private assets. Diversification into alternatives, he added, reduces risk.

He contended that keeping funds in investments that are more liquid—that is, easily converted into cash—is more valuable to short-term players than to endowments, which can afford to wait until private assets are sold or go public. He brushed aside concerns that most alternative investments are tied up for years and therefore illiquid. “Investors should pursue success, not liquidity,” he wrote. “Portfolio managers should fear failure, not illiquidity.” And again: “Accepting illiquidity pays outsize dividends to the patient long-term investor.”

For endowment managers, the Yale model appeared to solve a constant dilemma: how to generate returns high enough to support their operating budgets and simultaneously preserve capital for the future by allowing growth to keep up with inflation. Princeton, the Massachusetts Institute of Technology, and Bowdoin College hired Swensen protégés to run their endowments. By the 2007 fiscal year, colleges were devoting 42 percent of their endowments to alternative investments, up from 23 percent in fiscal 2000, according to Commonfund, a money manager for nonprofit institutions. Endowments grew so fast that many schools, including Yale, hiked their payouts—the percentage allocated to the operating budget. Private equity was particularly rewarding, averaging a 16.9 percent annual return to university endowments.Now, the recession that has already undone the reputations of Alan Greenspan, Robert Rubin, and other economic sages threatens Swensen’s too. Nearly every sort of alternative investment has been slammed, undermining Swensen’s diversification rationale, and his advice to downplay liquidity has backfired. With private donations dwindling and students clamoring for aid, universities that followed the Yale model find themselves in a plight that could be called cash-22. The publicly traded stocks they still own have plummeted in value, leaving the schools overdependent on illiquid alternatives—and constrained by contractual obligations to invest even more. The Yale model assumes returns when private holdings go public, but no initial public offerings are taking place.

From the best and brightest on down, most universities failed to anticipate this quandary. Harvard, Duke, Columbia, and the University of Virginia are looking to unload private equity at a loss by trading it on a secondary market that has emerged as a last resort during the cash crunch. Many schools are also trying to redeem shares in hedge funds—generally considered the most liquid alternative investment—only to encounter “gates” or “lockup clauses” in their contracts that prevent them from getting their money back. Brandeis University, which boosted its allocation to alternative investments from 29 percent of its endowment in 2003 to 65 percent in 2008, has seen its endowment drop 23 percent since June, and several of its big donors have been hit by losses in the Bernie Madoff fraud. To raise cash, Brandeis has considered closing its art museum and selling its renowned collection of contemporary art. Other schools are imposing salary and hiring freezes and delaying building projects. Like many investors who bet on mortgage-backed derivatives and similarly novel strategies during the boom, the Yale model’s adherents have painfully learned the old lesson that greater returns carry greater risk.

“Institutions were attempting to emulate the Yale model because it seemed to make sense,” says the chief investment officer for a university with a billion-dollar endowment. “Now this is the squeeze that everybody’s in. Were we wrong to go into this asset class? Is the asset class dead forever? Do we have to change the model going forward? These are all questions people are grappling with.”

Nevertheless, Yale doesn’t seem to be hurting as much as some of its imitators. That’s because Swensen, it turns out, hasn’t always followed his book’s advice. He pursued success and liquidity, employing lessons he had learned from prior bubbles and crashes to ensure ready access to cash. Now, with his counterparts at other top colleges dumping private equity investments in a panic, Swensen, ever the contrarian, is looking to buy more. Those who know him would expect nothing less.

Swensen tells me that Yale is about to break precedent and announce endowment results before the end of the fiscal year. They aren’t good: down 25 percent, to $17 billion from $22.9 billion. He concedes that the economic crisis has identified “real weaknesses” among some of Yale’s outside managers, including one who put together a land-development fund without enough capital. On the other hand, Swensen points out, he’s still beating the stock market, which has slid by an even greater amount. When critics deride the performance of alternative investments, “they aren’t asking, ‘Relative to what?’ Hedge fund returns are negative. That’s very disappointing, but they’re still far superior to equity returns,” he insists, spinning the numbers like a campaign manager. Although it’s too early to evaluate how private equity has done, he adds, “I’d bet, two or three years from now, when we look back, high-quality private equity managers will produce superior returns” to public equities.

Swensen disavows any responsibility for the troubles of other endowments that adopted the Yale model. He’s heard the attacks, he says: “Sometimes it’s me personally, or Yale. They put my name on it, or Yale’s name on it, and criticize the approach.”



p/s photos: Haruna Yabuki

Harvard University's Hedge Fund Business

The so called famous universities feed on its alumni, after a while they would have huge endowments. These endowments allow these famous universities to get the best students, as they can get the best professors and will even subsidise the tuition for gifted and deserving students. Harvard University had an added boost when they got very smart people to manage the endowment funds. The highly respected Jack Meyer and Mohamad El-Erian got spectacular returns for them. Budgets were plump, and students from middle-class families were getting big tuition breaks under an ambitious new financial aid program. The lavish spending was made possible by the earnings from Harvard's $36.9 billion endowment, the world's largest. That pot was supposed to be good for $1.4 billion in annual earnings. Below were excerpts from the article in Forbes magazine:

However, after years of superior performance, the last 12 months saw Harvard Management Co., the subsidiary that invests the school's money, suffering a very tough period. In particular their exotic financial instruments that were suddenly backfiring. Harvard had derivatives that gave it exposure to $7.2 billion in commodities and foreign stocks. With prices of both crashing, the university was getting margin calls--demands from counterparties for more collateral. Another bunch of derivatives burdened Harvard with a multibillion-dollar bet on interest rates that went against it.

It would have been nice to have cash on hand to meet margin calls, but Harvard had next to none. That was because these supremely self-confident money managers were more than fully invested. As of June 30 they had, thanks to the fancy derivatives, a 105% long position in risky assets. The effect is akin to putting every last dollar of your portfolio to work and then borrowing another 5% to buy more stocks.

Desperate for cash, Harvard Management went to outside money managers begging for a return of money it had expected to keep parked away for a long time. It tried to sell off illiquid stakes in private equity partnerships but couldn't get a decent price. It unloaded two-thirds of a $2.9 billion stock portfolio into a falling market. And now, in the last phase of the cash-raising panic, the university is borrowing money, much like a homeowner who takes out a second mortgage in order to pay off credit card bills. Since December Harvard has raised $2.5 billion by selling IOUs in the bond market. Roughly a third of these Harvard bonds are tax exempt and carry interest rates of 3.2% to 5.8%. The rest are taxable, with rates of 5% to 6.5%.

It doesn't feel good to be borrowing at 6% while holding assets with negative returns. Harvard has oversize positions in emerging market stocks and private equity partnerships, both disaster areas in the past eight months. The one category that has done well since last June is conventional Treasury bonds, and Harvard appears to have owned little of these. As of its last public disclosure on this score, it had a modest 16% allocation to fixed income, consisting of 7% in inflation-indexed bonds, 4% in corporates and the rest in high-yield and foreign debt.

For a long while Harvard's daring investment style was the envy of the endowment world. It made light bets in plain old stocks and bonds and went hell-for-leather into exotic and illiquid holdings: commodities, timberland, hedge funds, emerging market equities and private equity partnerships. The risky strategy paid off with market-beating results as long as the market was going up. But risk brings pain in a market crash. Although the full extent of the damage won't be known until Harvard releases the endowment numbers for June 30, 2009, the university is already working on the assumption that the portfolio will be down 30%, or $11 billion. That's a lot of free tuition for students down the drain when you consider they ar working on a $3.5 billion budget each year.

The strain of market turmoil is visible in staff turnover at the management company, which axed 25% of its staff recently and is on its fifth chief in four years. Jane Mendillo, 50, came to Harvard last July after running Wellesley's small endowment. She declines to comment. But how much blame she should get is unclear; the big bets on derivatives and exotic holdings were in place before she got there. The bad bet on interest rates--a swap in which Harvard was paying a high fixed interest rate and collecting a low short-term rate--goes back to a mandate from former Harvard president Lawrence Summers.The endowment will remain stretched. Harvard has been counting on it to fund more than a third of its $3.5 billion operating budget. Assuming the fiscal year ends with around a $24 billion endowment value, the university will be drawing down half again as high a percentage of its assets as it did in 2004, the last time the endowment was around that size. That can't go on forever. The strain on liquidity will continue, as the private equity partnerships compel Harvard to meet billions in capital calls in future years.

Why not just unload those partnerships along with the liabilities that stick to them? Because no one wants to buy them. Private equity stakes like Harvard's are selling at 40% to 60% discounts in various markets.

Harvard's woes are in some ways no different from those at other universities or in the market generally (the S&P 500 is down 37% since last July 1). "A loss in these kinds of markets is inevitable," says Michael Eisenson, a former HMC staffer who now runs private equity firm Charlesbank. The average endowment is down 23% in the five months through November, according to a university trade group.

But Harvard was supposed to be different. In the 15 years through last June it returned an annual 15.7% versus 9.2% for the S&P. Meyer landed at Harvard in 1990 after scoring big investment returns at the Rockefeller Foundation. In an unorthodox move for an endowment chief, Meyer built a Wall Street-like trading operation and managed most of HMC's money in-house. It looked like a giant hedge fund, and it had paychecks to match. A high-level HMC manager would make as much as $35 million in good years. Those sums triggered what became an annual Harvard tradition: first, the disclosure (compelled by tax laws applying to nonprofits) of the HMC bonuses, followed by an outcry led by the late William Strauss and a group of Harvard alumni from his class of 1969.

HMC not only became a place to make big bonuses, it was also where you could make a name for yourself and become a "crimson puppy," meaning launching your own private equity firm or hedge fund with Harvard's backing.

By September 2005 Meyer himself decided it was time to go. Some people say it was because of the persistent criticism about bonuses, which were reduced near the end of his tenure; others say he had run-ins with former U.S. Treasury secretaries Lawrence Summers and Robert Rubin, who assumed Harvard leadership positions at the start of the decade. Meyer denies both reasons and says 16 years at Harvard was simply enough.

Meyer formed his own hedge fund, Convexity Capital, which seems to have held up well in the current market. He took with him the Harvard heads of domestic and international fixed income, and both their staffs, as well as the chief risk officer, chief technology officer and chief operating officer. The survivors were demoralized. "You walked onto the trading floor, and it was just 10% full," says someone who was there at the time. "There was a sense that if you were good, you left."

Five months later Mohamed El-Erian, now 50, took over. The son of an Egyptian diplomat, he had risen to deputy director of the International Monetary Fund before joining giant bond manager Pimco. He seemed perfect for smoothing relations between HMC and the university. Filling the hole that Meyer left was another matter.

One solution: Don't even try, just hand over all of the endowment to outside money managers. But El-Erian insisted on keeping things intact. He talked of the "structural advantages" of investing a big endowment backed by an AAA-rated university, such as allowing you to borrow at low rates when making leveraged bets. The former Pimco emerging market superstar also believed that the developing countries offered big profits to smart investors like HMC because they had become less risky thanks to ample dollar reserves and a growing middle class.

So El-Erian upped HMC's exposure to emerging market stocks, which rose from 6% of assets when Meyer left to 11% two years later. He also used total return swaps to bet on developed world stocks and commodities on the cheap, freeing up money for other investments. El-Erian also took money from hedge funds he didn't like and redirected it to ones he thought were winners, putting hundreds of millions into funds in Latin America, Asia and the Middle East.

The moves looked brilliant. For the year ended June 2007 Harvard returned 23% versus 17.7% for 151 other big institutional investors (and 20.6% for the S&P 500). Fearing all markets could soon fall, El-Erian injected what he referred to as "Armageddon insurance" into HMC's portfolio for the first time by buying interest rate floors, or a wager that rates would fall, and betting, via credit default swaps, that companies could soon struggle to pay their debts.

For the following year, through June 2008, Harvard gained a spectacular outperformance of 8.6%, versus a 13% fall in the S&P. El-Erian's insurance accounted for much of HMC's outperformance. Hedge funds, however, were sucking up cash--HMC had increased investments in those areas to 19% from 12% a year earlier. The returns were flat.

Since July emerging market shares have been a disaster, falling 50%, as measured by the MSCI Emerging Markets Index, worse than U.S. stocks. Another problem: El-Erian's insurance has been partly taken off since he left, leaving HMC vulnerable when markets plunged this fall. The total return swaps, which easily could have been terminated, were left alone. The EFG-Hermes Middle East North Africa Opportunities Fund, a hedge fund launched in September 2007 with some $200 million of HMC cash, was down 35% in 2008. El-Erian's big hire, Taborsky, left HMC in September. He's since joined El-Erian at Pimco. El-Erian and Taborsky decline to comment.

By the time Jane Mendillo walked into HMC's offices in July 2008, she figured some changes needed to be made. A former consultant who worked for years at HMC under Meyer, Mendillo got the HMC gig partly as a result of Meyer's recommendation. She had spent the last six years running the $1.6 billion Wellesley College endowment, which was completely outsourced to external managers. Her detractors say that she was ill prepared for Harvard's liquidity crisis and slow to take cognizance of the swap exposure. But they concede that the crisis came fast on the heels of her arrival.

Mendillo did move quickly to deal with the private equity portfolio. One of her first moves at HMC, which she initiated before the markets started to fall in earnest, was to sell between $1 billion and $1.5 billion of Harvard's private equity assets in one of the biggest such sales ever attempted. The high bids on such assets have recently been 60 cents on the dollar, says Cogent Capital, an investment bank that advised Harvard on the sale. Cogent says the big discounts are due to "unrealistic pricing levels at which funds continued to hold their investments" and "fantasy valuations."

HMC has made $11 billion of capital commitments to investment partnerships through 2018, says Moody's. HMC used to make good on those commitments with income generated by the existing private equity portfolio. "Endowments are afraid capital calls will come quickly and far ahead of any liquidity from private equity funds," says Colin McGrady, managing director at Cogent Partners.

Watching all of this, the group of ten Harvard alumni from the class of 1969 feel vindicated. "The events of the last year show that the whole procedure of rewarding people so handsomely based on increases on paper value of the endowment was deeply flawed," says a spokesman for the group, which recently sent a letter to the Harvard president suggesting HMC staffers return $21 million of their latest bonuses. "Even now we don't really know how well it has done in the last ten years."

p/s photos: Shin Min Ah