Sunday, July 26, 2009

Harvard's lesson in asset/liability management

Any day now the Harvard Management Corporation (HMC), who manages Harvard's endowment, will release it's 08-09 school year annual return. Even though their performance in calendar 09 has stabilized, the new performance graph is likely to look something like this (dashed line):

It's certainly not the type of performance one should be proud of, but Harvard is by no means unique. Other institutions' portfolios, including endowments, pensions, insurance companies, etc. didn't fare significantly better.

Harvard's mistake was not as much in their asset allocation, but in their asset/liability management. They ran into a serious liquidity problem. Here is what the endowment's balance sheet looked like going into the financial crisis:

Source: HMC

Note that the "negative cash" number means they have been running some leverage for a while. That in itself is not necessarily an issue. Harvard's financial problems can be summarized as reliance on the endowment for operating income and on the continuous liquidation of private investments.

Recently as much as $1.2 billion of Harvard’s total annual operating income was coming from the endowment. The university came to rely on this and planned accordingly, building, hiring, expanding. Here is the latest publicly available breakdown of Harvard's operating income:

The endowment was effectively viewed (and used) as a fixed income annuity. It's amazing that a bunch of really smart people would manage their resources this way. It's equivalent to a retiree who has her pension in a hedge fund. Again, Harvard is by no means unique in this - they are just he largest.

The investment profile (see chart below) looks more like an aggressive portfolio with a 10 - 20 year time horizon.

HMC's non-cash portfolio

Source: HMC

The second problem Harvard (in particular HVC) ran into was their reliance on the steady flow of cash from "harvested" private investments. Using historical experience with private equity and real estate funds HVC made the assumption that each year some of these private investments will be monetized by private equity firms with which they had invested. The older the fund "vintage" the more "harvesting" one would expect, and HVC projected some nice monetizations for 08-09 school year.

The "harvest" was poor to say the least, given what we just went through. Monetizations rely on strategic acquisitions, LBO (or CMBS based) acquisitions, and IPOs. The first two generally rely on debt financing, which as we know had collapsed. The IPO market hasn't been exactly active either.

What made things really difficult for HMC was that going into the crisis, they had some $10 - $12 billion of unfunded commitments. Normally these would be financed with monetizations, but this time cash wasn't coming in. With leverage, HVC had no real cash reserves and was forced to liquidate some equity and fixed income investments in the worst possible time. HVC also got out of some hedge funds, but many funds had put up gates or had lock-ups.

In addition to capital commitments to private equity funds, the university had commitments to construction projects and other programs that it couldn't easily get out of. Harvard desperately needed additional liquidity. HVC put $1.5 billion of fund investments with unfunded commitments for sale. Secondary private equity funds were bidding 50-60% to take that off HVC's hands. Not clear how much was actually transacted.

This liquidity crisis sent shock waves through the university. Harvard had to raise funds in the capital markets at arguably the worst possible time, December - 2008. They issued $3 billion worth of bonds half of which were privately placed:
$1 billion @ 5.0% maturing 2014
$1 billion @ 6.0% maturing 2019
$1 billion @ 6.5% maturing 2039
It is rumored that some of the issue was placed below par and some was retained by Harvard. This forced them into a fairly high cost of debt capital for a AAA issuer.

In addition to "resolving" their liquidity problems, Harvard also proceeded to restructure HMC. Rather than having numerous business areas, Jane Mendillo (who took over HMC in mid-08) created two divisions - one responsible for all external investments (effectively a fund of private equity funds and hedge funds) and the other for the internal portfolio. The internal portfolio team follows a set of allocation guidelines across "liquid" bonds and equities with a hedge fund-like trading overlay. HMC is active in interest rate spread and volatility trading, taking positions globally. The internal fund is also active in emerging markets, equity long/short and volatility trading, commodities, as well as some currencies.

Latest HMC org structure:

It's a decent setup assuming they have worked out their asset/liability problem. Feeding the university and committing to private investments requires much larger cash reserves and a more active liquidity management process than what they had in place going into the crisis.

This has been a superb risk management lesson for Harvard. Successful endowment management means more than skillful trading, hyper-charged portfolio allocation, and aggressive performance targets.

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