Has HMC Lost Its Edge?

Perched sixteen stories above street level in the Boston Federal Reserve Building, the office of Jane L. Mendillo offers majestic views of boats bobbing in Boston Harbor and planes touching down at Logan Airport. Sitting two levels above a bustling trading floor, Mendillo not only occupies one of the nicest offices at Harvard but, as CEO of Harvard Management Company, influences the University’s financial strength more than even the most celebrated Harvard donors.

At HMC, the stakes are high. Tasked with managing the largest endowment in higher education—valued at $32.7 billion as of July 2013—HMC’s managers operate with the knowledge that even the smallest margins translate to millions of dollars. To put it another way: a difference of a single percent in annual returns at HMC represents an amount—nearly $330 million—that is more than twice the size of the largest gift announced so far in the University’s record-seeking capital campaign.

Harvard Management Company
  • Founded in 1974
  • Manages significant segment of endowment in-house, which is not the norm for universities
  • Based in the Boston Federal Reserve Building
  • Special focus on alternative assets like real estate, natural resources, and private equity

Mendillo has been credited with helping stave off disaster during the nadir of the global financial crisis in 2009, when HMC saw endowment returns of negative 27.3 percent. Each day during the recession, Mendillo convened her senior staff for a 7 a.m. crisis meeting. Today, with the meltdown in the rearview mirror, those meetings have ceased, and the endowment has started to recover. Although the fund is nearly $7 billion stronger than it was in 2009, Mendillo says the pressure of managing such a large endowment is constant.

“It’s an extra challenge,” she said in her office in mid-May. “It’s a huge responsibility.”

Yet since the crisis, HMC—in a shift away from record yields in the 1990s and early 2000s—has posted returns that have straddled the national average. In this new normal, a far cry from HMC’s early-2000s status as the envy of higher education, University leaders say HMC is fulfilling its charge of beating internally set benchmarks and holding more liquid assets in case another crisis hits. But as Harvard seeks to raise an ambitious $6.5 billion in its ongoing capital campaign, the numbers do not lie: HMC is not performing as well as it used to.

The Golden Years: Jack Meyer And The ‘Yale Model’

Today, HMC is closer to average than it has been in a long time. In two of the last four fiscal years, the company has posted returns that have trailed the average reported by the National Association of College and University Business Officers—an organization that conducts an annual survey that included more than 800 schools in 2013. In three of these years, moreover, HMC has performed below the national average for endowments worth more than $1 billion.

HMC has also lagged behind other large endowments in recent years. In FY 2012, Yale posted a return of 4.7 percent, outpacing Harvard, which returned -.05 percent. Princeton was also in the black in FY 2012, returning 3.1 percent. And last fiscal year, Yale, Stanford and Princeton each posted higher returns than HMC.

It was not always this way. HMC under the leadership of CEO Jack R. Meyer beat the general NACUBO average each year between 1996 and and 2005, emerging with Yale as one of the nation’s most rapidly growing endowments. During the same span, Meyer’s HMC only underperformed against the $1 billion plus average twice.

When Meyer arrived at HMC in 1990, he inherited a fledgling company designed to shepherd the investments of an endowment worth $4.7 billion. Over the next 14 fiscal years, Meyer more than tripled that figure, attaining celebrity status with University leaders and supporters. When he left his post in 2005, the endowment had grown to $25.9 billion.

Like his predecessor Walter M. Cabot ’55—who took office in 1974 as HMC’s founding CEO—Meyer invested in line with what is known as the “Yale endowment model” developed by Yale Chief Investment Officer David F. Swensen, channeling the endowment into a range of alternative asset classes such as private equity and real estate rather than a more traditional mix of domestic stocks and bonds.

Jack R. Meyer
  • Led HMC from 1990 until September 2005
  • Increased endowment nearly fivefold, leaving it with a value of $25.9 billion
  • Massive gains earned respect of alumni and University leaders
  • Sparked a controversy with the lavish sums he paid his top managers

An especially lucrative asset class under Meyer’s reign was private equity, investments in firms that purchase and restructure private companies for eventual sale. Between 1997 and 2007, HMC’s private equity investments generated annualized returns in excess of 30 percent.

When the Yale model works, these alternative asset classes bring investors the potential for elevated returns at the expense of liquidity, meaning the investments—while perhaps more profitable—are not nearly as easy to unload as typical stock-bond portfolios.

The focus on alternative assets like private equity was so successful between 1997 and 2007 in part because it gave endowments like those of Harvard and Yale a distinct comparative advantage. Because of the value of Harvard’s endowment, HMC was able to gain access to private equity firms that might not have allowed smaller funds to participate. This access was only accentuated, for both Harvard and Yale, by the concentration of the schools’ alumni in private equity.

“I don’t think it’s ever going to be true that most of the good managers on Wall Street are from any place other than Harvard,” said David L. Yermack ’85, a professor of finance at the Stern School of Business at New York University. “Because of that, the University is going to get access and information that just isn’t going to be duplicated by any other competitor, and that’s a fairly timeless advantage that works very much in Harvard’s favor.”

For a time, then, HMC and a few other large endowments were the first guests at a very lucrative party. But the comparative advantage eventually subsided, as other funds seized on private equity and other aspects of HMC’s winning strategy. In the last 10 years, HMC’s private equity assets have yielded an annualized return of slightly over 9 percent, a fraction of the 30 percent returns the company reaped from that class of assets during the peak of its growth.

But HMC is not running away from private equity. In fact, since FY 2008, it has increased its target allocation to the asset class from 11 percent to 16 percent, according to HMC’s FY 2013 annual report.

“We still like the asset class, but the expectations need to be somewhat muted,” Mendillo said in her office in May, adding that given the increasingly crowded nature of the asset class, it will be difficult to replicate the private equity premium that fueled the endowment for the past 20 years.

Despite Mendillo’s caution, HMC’s persistence in private equity has some experts perplexed.

“You can’t keep going back to the same playbook because competition and the entry of competitors bid away the returns,” Yermack said.

Coupled Crises

In the early 2000s, Harvard's endowment, buoyed by its private equity holdings, was still soaring. It would take a financial crisis that penalized institutions with illiquid holdings, along with turnover at the top of HMC, to bring the company back to the pack.

By the 2000s, Meyer had emerged as the confident, unapologetic face of HMC. But facing a chorus of criticism from alumni and other Harvard supporters over the compensation of HMC’s high-level executives, Meyer left the company in September 2005, taking about 30 of the firm’s investment professionals with him to the private sector.

Mohamed A. El-Erian
  • Shortest termed non-interim CEO of HMC. Served Feb. 2006 until the end of 2007
  • In only full fiscal year, generated 23 percent return

His departure marked the beginning of a period of uncertainty about the direction of HMC. The Corporation tapped Mohamed A. El-Erian, a managing director at Pacific Investment Management Company with no ties to the University or experience with institutional funding, to succeed Meyer. But less than two years later, El-Erian resigned his post after leading HMC to a 23 percent return in FY 2007, throwing the company’s helm into disarray.

On the eve of a global financial crisis, and while the University’s core leadership in Cambridge was being reshuffled as well, the high leadership turnover caused unwelcome variability at HMC. When Mendillo arrived as the firm’s new permanent CEO in July 2008 after six years managing the endowment at Wellesley College and over a decade at HMC before that, she found a firm still reeling from the repeated changes in management.

“I found that there had been a fair amount of instability in the interim,” she said this spring. “Our relationship with the University wasn’t as close as it should have been.”

And soon, Mendillo had more than internal issues to worry about. From her first meetings at HMC in July 2008, the new CEO—who inherited the endowment at a record-high value of $36.9 billion—began to see signs that the market was cracking in places where HMC was heavily positioned. By the fall, the markets were in full tank and private equity, where HMC had targeted about 11 percent of its investments, was among the asset classes in the worst shape. To answer calls on these increasingly poisonous holdings, HMC had to sell precious liquid assets, increasing the blowback of what quickly became a serious liquidity crisis.

All told, HMC lost about $11 billion from the endowment in FY 2009, a drop of 27.3 percent. At the same time, in the face of declining revenues from areas like tuition fees, the University desperately needed an infusion of cash. After FY 2009, the Harvard Corporation increased the endowment payout rate to the University’s operating budget to 6.1 percent. Though this was the highest rate in at least 40 years and was up more than one percent from the previous year, the percentage bump still did not make up the operating budget’s loss resulting from the huge decrease in endowment value.

In response, the University was forced to make deep cuts: hundreds of staffers were laid off, hiring freezes were installed, and hot breakfast was eliminated for undergraduates. In Allston, an ambitious construction plan set by then-University President Lawrence H. Summers was cancelled and, after Summers resigned, interest rate swaps pegged to the construction were left on the books even as work stopped. As the positions declined in value, HMC had to repeatedly post collateral for the University, according to Mendillo. The swaps were eventually unwound at a huge loss.

“At the same time that we were experiencing distress in the portfolio and illiquidity in the portfolio, the University was also experiencing an unusual amount of financial need and distress and so the two things just came together,” Mendillo said this May. “We realized in this terrible moment, say October or November [2008], that there were a lot of things that weren’t in place the way they should have been.”

A New Mandate, And New Tradeoffs

The financial crisis had an immediate and lasting impact on all parts of Harvard, from HMC’s offices at the Boston Fed to the headquarters of the Faculty of Arts and Sciences in Harvard Yard. As University officials enacted painful budget cuts and staff reductions, leadership began to rethink how to make HMC work for Harvard.

“It’s not that the right hand didn’t know what the left hand was doing, but it was a situation in which HMC could have had greater understanding of what the financial needs of the University were going to be, not just a year out but three or four years out,” Robert D. Reischauer ’63, the senior fellow of the Harvard Corporation, said in an April interview.

After the crisis, under the leadership of Reischauer and University President Drew G. Faust, Harvard launched a dramatic reform of the Corporation, including the creation of a finance committee that oversees HMC. Mendillo participates in meetings of the finance committee, a new experience that Reischauer and Lee both called valuable.

From the increased interactions between HMC and the Corporation has emerged a mandate that is unquestionably more conservative than the playbook Meyer followed.

Jane L. Mendillo
  • President and CEO of HMC since 7/1/2008
  • Previously managed Wellesley endowment and spent over a decade as a manager at HMC
  • Graduate of Yale College and Yale School of Management

“If you’re 1 percent off your benchmark, but a $30 billion plus portfolio has a risk profile that’s more acceptable to us long-term and a liquidity profile [that’s more acceptable], then that’s a fair tradeoff,” said William F. Lee ’72, who will succeed Reischauer as the senior fellow this summer. “You’re going to have to make tradeoffs like that.”

One change has come in the way HMC deals with external managers.

“External management doesn’t necessarily mean that you’re illiquid or locked up, but we did have some situations in place in 2008 where some portion of our public equities were locked up,” Mendillo wrote in a statement to The Crimson this May. “We’ve changed that so that even when we use external managers, our assets are available to us within a few days or within a month, or at the most, within a quarter.”

Another significant shift has been the reversal of a decades-old policy at HMC. Under Meyer, HMC borrowed cash and invested it with the goal of earning returns that exceeded borrowing costs. After the crisis, Mendillo reversed this policy. Additionally, in another change meant to create more liquidity, the University has moved monies out of the endowment itself for reserve purposes in recent fiscal years.

The cash movements are the clearest manifestation of HMC’s new mandate, and the new direction has its tradeoffs.

“When you take cash that you’re not investing in what you think are the most ambitious possibilities, you are using it for a safety net,” Faust said in an interview in May. “That will have an effect on the performance of the endowment.”

Ambitious Campaign, Average Returns

HMC’s returns of late are modest compared to the company’s pre-crisis performance, but even so, recent HMC annual reports have emphasized the strength of the endowment’s recovery. And while a dollar donated to Harvard today may not yield the same astronomical returns that it would have two decades ago, many University supporters say they trust HMC’s record.

HMC’s public documentation since the crisis has encouraged this trust. Though the report for FY 2009 dwelled on the record losses that year, reports since then have focused on the recovery. In FY 2012 and FY 2013, HMC replaced its traditional five-year average annualized return metric with a three-year figure, which did not include the worst of the crisis.

“There was nothing nefarious about the timeframes we chose,” Mendillo said in her office this May. “I think people are more interested in what’s happened since [the crisis], so we thought when we looked at it that the one, three, 10, and 20 [year averages] were more interesting and meaningful numbers.”

Moreover, HMC has consistently emphasized its performance against internal benchmarks as a sign of success. But while Mendillo insists that beating the benchmarks is “not easily done and... not expected every year,” the company has exceeded its overarching internal benchmark in each of the last four fiscal years.

Speaking anonymously, some influential University supporters have criticized not only HMC’s post-crisis returns as frustratingly average, but also questioned the Company’s shift in reporting procedure and emphasis on internal benchmarks, which may not account for HMC’s size and access advantages with some asset classes, like private equity. Still, a larger chorus of prominent donors say they agree with Mendillo’s emphasis on the recent recovery and on HMC’s long-term strength.

Kenneth Lipper, a 1965 graduate of Harvard Law School and a former member of the Committee on University Resources, a group of Harvard’s top donors, said that while HMC has had down years, its long-term record is impressive.

“I’m not worried,” Lipper said in an interview this May of losses connected to private equity and other illiquid assets. “It’s not surprising that [Harvard’s] endowment or the Yale endowment, which were heavily into those kinds of things, could suffer disproportionate losses because of the type of investments they were involved in.”

Lipper added, “I wouldn’t be too rushed to jump to a judgment. See how they do in the next two years and then make a judgement.”

Kenneth C. Griffin ’89, the benefactor of the largest announced gift in the history of the University—$150 million in February 2014—says that HMC’s record is critical to University strength, and no one can deny the long-term success the company has enjoyed.

“Harvard Management Company has successfully deployed the capital of our endowment in a way that really is the envy of most other institutions,” Griffin told The Crimson in May. “They’ve had their ups and downs, but its really really hard to argue with their track record of success.”

—Staff writer Amna H. Hashmi contributed to the reporting of this story.

—Staff writer Christine Y. Cahill can be reached at christine.cahill@thecrimson.com. Follow her on Twitter @cycahill16.

—Staff writer Matthew Q. Clarida can be reached at matthew.clarida@thecrimson.com. Follow him on Twitter @MattClarida.

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