Thursday, March 12, 2009

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

1 comment:

see said...

Harvard's $36 bil endowment?! Hell, they big enough to rescue GM