[Pen-l] Harvard's financial meltdown

[Louis Proyect <lnp3@xxxxxxxxx>]

http://www.forbes.com/forbes/2009/0316/080_harvard_finance_meltdown.html
Harvard: the Inside Story of Its Finance Meltdown
Bernard Condon and Nathan Vardi 03.16.09, 12:00 AM ET

Stocks were tumbling last fall as the new school year began, but at 
Harvard University it was as if the boom had never ended. Workers were 
digging across the river from Harvard's Cambridge, Mass. home, the start 
of a grand expansion that was to eventually almost double the size of 
the university. 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.

Behind the scenes, though, a different story was unfolding. In a 
glassed-walled conference room overlooking downtown Boston, traders at 
Harvard Management Co., the subsidiary that invests the school's money, 
were fielding questions from their new boss, Jane Mendillo, about 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 (among them, jpmorgan Chase 
and Goldman Sachs) 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.

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. 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.

Jack R. Meyer, 64, a revered money manager who headed Harvard's 
endowment until 2005, offers a few guarded comments. "The liquidity 
thing most concerns me--that should not have happened," he says. Though 
he wasn't there at the time, Meyer says Harvard Management bought the 
commodity and foreign stock derivatives as a way to get exposure to 
those asset classes while freeing up cash to put to work elsewhere. The 
strategy, he says, "drained liquidity" from the endowment in recent 
months. "Many endowments stretched too far, and I think Harvard did as 
well," he says.

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. 
"Endowments will be shocked at the valuations of their [private equity] 
portfolios," says Stewart Massey, an endowment consultant at Massey 
Quick. "It's going to be an absolute bloodbath."

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. One of the puppies, Jeffrey Larson, left in 2004 to start 
Sowood Capital. That pile of smart money cratered in 2007, losing $350 
million for Harvard.

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. Tapping former 
Stanford endowment staffer Mark Taborsky (an "important hire," El-Erian 
would later write in a book), 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 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.

It's unclear how much of the results--good or otherwise--were El-Erian's 
doing. He left at the end of 2007, six months before the results came 
in, citing a desire to move back near his wife's family in California 
and return to Pimco as heir apparent to founder Bill Gross.

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."

Defenders of Harvard's portfolio argue the secondary market is 
discounting private equity stakes too much. The market is made up of a 
dozen secondary funds with at most $15 billion available, says Bryon 
Sheets, a partner at San Francisco secondary firm Paul Capital. That 
makes it a buyer's market, given the slew of desperate banks, funds and 
endowments looking to unload assets to meet obligations.

So what are Harvard's private equity stakes worth? Most private equity 
investors like Harvard have been waiting for their money managers to 
finish marking down their assets following a brutal 2008. It is a slow 
process that lags the public markets by as much as 180 days, says 
William Frieske, a performance consultant at Northern Trust, which 
administers endowment accounts.

But one clue to what may be coming can be found in Harvard's own 
portfolio. It owns units of Conversus Capital, a publicly traded vehicle 
that holds slices of 210 private equity funds. Conversus has cut its net 
asset value by 21% since last summer to make a "best estimate." Yet 
stock investors think things are a lot worse. Conversus shares have 
fallen 67% since June 30 and are trading at a 62% discount to the net 
asset value. The Conversus stock drop translates into a potential $168 
million loss for Harvard, which as of Jan. 31 was still listed as a 
"strategic investor."

Conversus is run by Robert Long, a former Bank of America exec who went 
to Boston and got $250 million from El-Erian to help him set up the firm 
and buy $1.9 billion of Bank of America's private equity assets.

Harvard also owns a piece of Garnett & Helfrich Capital, a $350 million 
fund opened in 2004. Garnett has purchased six companies but five years 
later has yet to realize any returns. The value of one of those 
investments, software maker Ingres, has been reduced by its minority 
owner to nothing "as a result of reported losses." Then there is 
Tallwood Venture II, a $180 million fund raised in 2002 to invest in 
semiconductors. It has hardly exited any of its portfolio companies, 
according to Thomson Reuters and sec filings.

The fact that a fifth of HMC's portfolio is in private-equity-like 
investments makes it vulnerable to the kind of problems HMC faced this 
fall. 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."
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