Saturday, March 14, 2009

Is Harvard A Hedge Fund?

Harvard has problems. Billion dollar problems. Exactly how many billions of dollars remains in dispute. What is beyond dispute, however, is that Harvard has lost around a quarter of its endowment in the last nine months, and a large part of the remaining funds are tied up in illiquid investments. This is quite a reversal. Indeed, only a year ago endowments at Harvard and other elite schools had swollen to such gargantuan sums that they were busy devising ways to spend enough to maintain their tax-exempt statuses. There was even talk of using the endowment to make Harvard free for all students. Ah, those heady pre-Lehman days. Of course, it is hardly surprising that Harvard's endowment has not been immune to the global financial turmoil. Markets everywhere have cratered. But the nature of Harvard's losses illustrates the extent to which the university has aggressively moved into nontraditional investments - "real" assets like forests and oil, as well as stakes in private equity. Harvard has become a hedge fund. But why did Harvard transform itself, as Jim Manzi wryly opined, into a "tax-free hedge fund with a very large marketing and PR arm called Harvard University"? And what does this tell us about how the bubble economy skewed our perspectives, and created perverse incentives to join the speculative crowd?

Because it was lucrative. Very lucrative. This is the short answer to why Harvard began managing its endowment like an amped up Wall Streeter trying to max out just before bonus season. This is not hyperbole. Ex-Wall Street alums ran the endowment, and were compensated along the same bonus system (although the Harvard Management Corporation did wisely include clawback provisions). As Edward Jay Epstein notes, they moved out of the types of assets endowments had traditionally held, such as Treasuries and other bonds, and into a broad range of often obscure, illiquid investments. After all, there were oversized fortunes to be made in these exotic bets. And Harvard made them. Under Jack Meyer's stewardship, Harvard's endowment ballooned from $4.7 billion in 1990 to $22.6 billion in 2005. Aggressive management accounted for at least $12 billion of this growth; 15% annual returns will do that.
Of course, it was not simply a Scrooge McDuck hoarding instinct that motivated this shift in investment strategy. The scorched earth competition that is elite higher education demanded it. As colleges entered an arms race in the last fifteen years to attract the best faculty and students, costs skyrocketed. There was an education bubble. And even a school with as strong a brand as Harvard could not afford to let its near peer institutions outspend it on research facilities, dorms, and professors. As former Citigroup CEO Chuck Prince remarked nearly two years ago about the credit boom (in a statement that retrospectively highlights the collective cluelessness of our erstwhile financial titans), "as long as the music is playing, you've got to get up and dance." So Harvard danced.

Harvard needed little cajoling to get up on the metaphorical dance floor. This unreserved jump into heretofore abstruse markets hints at the final dimension of the Harvard endowment's metamorphosis into a speculative enterprise: the school's changing culture. Beginning in the 1980s, increasing number of Harvard graduates flocked to Wall Street to get rich. According to Harvard economists Claudia Goldin and Lawrence Katz, the number of graduates going into finance grew from 5% in 1970 to 15% in 1990. A survey of the class of 2007 revealed that 20% of the men were headed for Wall Street. And who could blame all these wannabe Masters of the Universe - alumni in finance earned on average three times more than their former classmates in other fields. What explained this explosion in financial sector salaries? No one is quite sure. If anyone could explain, it would almost certainly be business journalist Michael Lewis, who had a firsthand view of the genesis of this brave new financial world while at Salomon Brothers. However, even he is slightly flummoxed. As Lewis explains in Liar's Poker, the money was just there. In terms of supply and demand it made little intuitive sense. Some confluence of new freedom from regulatory strictures and a generational forgetting of the toxicity of excess debt created a frenzied era of seemingly exponential growth for Wall Street. It certainly seems that by the early 1990s, recent alums and current students had so bought into the Wall Street way that maximizing the endowment's returns seemed obvious; following a conservative strategy would be an inefficient use of capital, after all. Now it is certainly possible that the changing career choices of Harvard alums had little or no impact on the investment strategy of the HMC. The fact that hosts of grads descended on the investment houses and the endowment reoriented towards higher-yielding (read: riskier) assets could both merely have reflected the immense profitability of the Great Bull Market.

Without large parts of the Harvard community internalizing the Wall Street ethos, it seems unlikely that the HMC would have been able to justify its shift in investment philosophy. Indeed, even this was not enough once HMC remuneration peaked in 2004. To some alumni who came of age before the go-go 1980s, the outsized paychecks HMC handed out to the endowment's managers were disquieting. Several members of the class of 1969 began a letter-writing campaign, and ultimately succeeded in pressuring the administration to establish pay caps. The student newspaper the Harvard Crimson, however, was not impressed. They told alumni to "stop calling for salary cuts" and end the "excessive scrutiny" of HMC - otherwise the university would be unable to retain its top financial talent. Besides, HMC did not pay its employees nearly as much as a hedge fund with identical returns would receive. Don't kill the goose that laid the golden nest egg.

They had a point. While paying a combined $70 million to two bond traders in 2004 stoked outrage, this was a pittance compared to what Harvard would have had to pay to an outside firm for the same results. However, arguing that capping pay was short-sighted presupposed a key issue: that Harvard was a hedge fund. During the boom years, this might have seemed a pedantic point, but the current downturn has demonstrated the downside of running an endowment like George Soros runs his hedge fund. Like colleges everywhere, Harvard has instituted a hiring freeze, halted construction on new projects, and fired staff to cut costs in response to the global financial crisis. These austere measures have prompted a torrent of criticism. Despite its losses, Harvard's endowment still dwarfs those of other schools; indeed, Harvard has lost more than most ever had. Given the university's relative wealth, shouldn't they use the endowment to maintain services? Some contended the university was acting as if capital preservation mattered more than the students. Such are the dangers of turning a university into an investment vehicle.

Harvard is hardly alone in transforming itself into a hedge fund. The trend began with Wall Street itself in the 1980s. It is easy to forget now, but investment banks did not always trade on their own books. They advised companies on mergers and acquisitions; they underwrote securities; they executed trades for clients. But as Michael Lewis chronicles in Liar's Poker, the trading culture quickly spread from Salomon Brothers throughout Wall Street once it became clear what kinds of fortunes stood to be made. Institutional investors - university endowments, pension funds, and insurance companies - followed suit. Big ticket manufacturers - GE and GM - got in on the act as well, turning their financing arms into cogs in the larger banking system. At the bubble's peak, entire countries - yes, that means you Iceland - effectively leveraged themselves up and became de facto private equity firms and hedge funds. Why did everyone and their aunt borrow to speculate in the markets? Because they were afraid of being left out. They saw their relatives and neighbors and rivals making a quick buck, and they didn't want to be the sucker who didn't get rich. They let social pressure cloud their judgment. Their early "successes" in the markets only reinforced these pressures, and warped their values, sending them into self-congratulatory fits about how brilliant they were for doing so well.

But now that the age of leverage is over, never to return in our lifetimes, we must all go back to doing what it is that we did before the markets made us crazy. Iceland needs to go back to fishing; GE and GM need to go back to building wind turbines and cars; pension funds and insurance companies need to invest in safe, boring assets; and Harvard has to go back to just educating its students. A new age of responsibility is most certainly upon us.

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