The Makers of Harvard's Millions

Perched atop a veritable goldmine—$19.2 billion and counting—Harvard is richer than any University in the world.

With its coffers full to overflowing, Harvard’s endowment is larger than the budgets of more than 100 countries and larger than the endowments of Brown, Dartmouth, Columbia, Princeton and Cornell combined.

But how the University came to have such staggeringly deep pockets—nearly twice the size of second-place Yale—is the story of one of the University’s least-known sectors—the Harvard Management Company (HMC).

HMC is unique to Harvard for its mission: It makes money. Its only task is to give the University the maximum return on its investments—a task that has by all accounts met with wild success since HMC’s inception in 1974.

Harvard hires the best portfolio managers it can find, offers them multi-million dollar compensation packages and gives them wide autonomy to invest its endowment—with almost a quarter of HMC’s funds going into high-risk assets like venture capital and real estate.

HMC’s strategy is considered cutting-edge for institutional investing, says Michael P. Manning, a senior partner with New England Pension Consultants, an investment consulting firm.

“Harvard Management is the premier university investor; it’s one of the most sophisticated endowments in the nation,” says Mitch Sacks, an analyst with Zachs Industry Research in Chicago. “Generally speaking, it’s one of the most highly regarded investment firms in the nation.”

And though the University’s investments have at times been highly controversial, the sheer magnitude of the final product has caused much of that controversy to fall by the wayside.

“The results speak for themselves,” says D. Ronald Daniel, University treasurer and a member of the Corporation, Harvard’s highest governing body.

Last year alone, Harvard saw its endowment jump almost a third, from $14.4 to $19.2 billion—an increase larger than the entire endowment of universities like Dartmouth, Cornell and Duke.

And that jump was largely thanks to a ground-breaking investment strategy begun during the Nixon administration, when Harvard decided that it could beat the market by privatizing its investments.

From the Cradle

to the Moneybin

HMC was born out of Harvard’s decision in the early 1970’s that it needed a radical change in its investment strategy, after a decade of stagnating returns when the growth of Harvard’s endowment barely kept pace with inflation, growing only about 25 percent.

Even so, Harvard needed to ensure that the University’s resources, scale and the size of the permanent endowment would allow it to thrive in the competitive market before it created its own investment company.

“It does take scale, and there aren’t a lot of universities that have endowments large enough to make [internal management] work,” says former HMC investment manager Scott Sperling.

When HMC was created, Harvard was unique in the national field. And even now only a handful of universities—Yale, Princeton, Stanford, and the University of Texas, among others—have internal investment managers.

“In Harvard’s case, they’ve made it work, but there were times when it looked like it wouldn’t... It’s taken a lot of time to get comfortable,” says John S. Griswold, senior vice president of The Commonfund, a mutual fund for institutional investors that was established three years before HMC and currently manages over $26 billion for more than 1,400 colleges, universities, and foundations.

But Harvard has never used The Commonfund. With a significantly larger and more diverse endowment than most other schools, Harvard is a giant among giants, which thinks that regular investment techniques are just not good enough.

“The basic reason is that they’re different,” Griswold says. “They feel they are able to invest in a way that will return them above average returns.”

Harvard faced a unique challenge when it opted to take its endowment private, with little precedent on which to base its decision.

Harvard’s endowment is far more diversified than schools like the University of Texas, which has accumulated its $7 billion endowment thanks largely to land grants and Texas-based oil interests. A gift of Coca-Cola stock makes up almost half of Emory’s endowment. But because the scope of Harvard’s portfolio is so wide, Harvard has an increased need for shrewd and decisive investment.

When Walter M. Cabot ’55 set up HMC in a giant glass-paneled office on the 26thfloor of the Federal Reserve Building in downtown Boston, he began a term as president and CEO that would last for almost two decades.

Under Cabot’s watchful eye, Harvard’s endowment grew from one to five billion dollars, thanks largely to a radical move into aggressive investment in private equities known in the industry as “alternative assets”—venture capital, oil and gas futures and real estate.

At the time, many industry experts considered HMC’s move risky, but Cabot recognized that the endowment’s long-term view could withstand the day-to-day volatility of the market.

“The question of how best to invest an endowment is different from the normal institutional investor,” says Robert M. Pease, senior editor of Private Equity Analyst, a Wellesley-based industry newsletter.

“If you look at a pension plan, they have to match assets and liabilities over the short, medium, and long term, whereas an endowment is primarily interested in the long-term growth,” he says.

Cabot met with further success in the venture capital business, which HMC entered just as the 1970s technology boom began.

Endowment returns also benefited from HMC’s entry into the business of leveraged buyouts and financing mergers.

“In going after returns, they were creating more efficient and more profitable companies in their wake,” Pease says.

In 1983, Harvard was the envy of other Universities, with an endowment return of 43.3 percent—almost double the total return for the 15 years prior to HMC’s creation.

He adroitly maneuvered Harvard through the 1987 stock market crash—saving Harvard tens of millions of dollars.

But by the end of the 1980s, Cabot’s luck seemed to have run out.

In 1988, HMC became entangled in a leveraged buyout of RJR Nabisco, prompting controversy over whether Harvard should be involved in hostile takeovers.

And Cabot’s reluctance to reinvest in the stock market caused HMC to miss the 1989 stock rebound, costing Harvard millions. By 1989, endowment returns had sunk to a quarter of 1983 rates.

Then in 1989, HMC suffered one of its most public investing debacles. HMC lost about half of a $45 million investment—then about one percent of the endowment—in risky “commercial papers” of Lomas Financial Co., sold by Merrill Lynch, a loss that was aired publicly when HMC filed a lawsuit to recover the losses.

HMC’s annual report in 1989 concluded that though substantial talent existed within the organization, “stronger management” was needed at the senior level.

Sources close to HMC say a combination of Cabot’s failing health and concerns from Harvard about declining returns led the University to begin seeking a replacement in 1990.

Pressure was also building in the early 1990s for Harvard to shift more towards the model of the Princeton Investment Company (PRINCO)—which outsources large amounts of its endowment—or to enter a Commonfund-type arraignment.

Despite Cabot’s early successes, The Commonfund had outpaced the Harvard endowment by a full percentage point during Cabot’s time as head of HMC.

“The fact is that compared with other large endowment funds, The Commonfund has generally done a little better over time,” said then-Commonfund President George F. Keene.

Meyer Takes the Helm:

Cabot’s replacement, Jack R. Meyer, came to Harvard from the Rockefeller Foundation, where he served as the CIO for an endowment that outperformed Harvard’s own—his former boss called him the “Ty Cobb of fund managers.”

Meyer told newspapers that his new position at HMC was the “perfect job.”

He pursued an even more aggressive investing strategy than Cabot’s, even though Harvard was held more accountable for its investments.

He revamped HMC’s compensation structure so that it rewarded longer-term performance and tied its structure to benchmarks selected by HMC’s board of directors that “outperform[ed] the average manager,” according to Meyer.

“That’s the whole point of active fund management. If we just wanted to match the market, we could do that with an index fund,” Meyer says.

But Meyer’s new tack left ruffled feathers among Cabot’s former staff, and five high-level investors left the firm in the first year of Meyer’s term.

Aiming Higher

Meyer’s changes paid off during his first three years as HMC president, and in 1993, the endowment returned 16.7 percent.

In 1997 HMC reported that the endowment had grown to $10.8 billion, returning 26 percent in a year when the industry average was 17.6 percent for other large institutional funds.

Meyer said the lead of 8.4 percentage points over other big investors was the largest in HMC’s 22-year history.

At this point, Meyer says HMC began a discussion about whether the endowment had outgrown HMC and whether parts of the endowment should be outsourced. There was even discussion of breaking up HMC entirely in separate smaller firms.

But ultimately Harvard’s directors decided that the endowment benefited from the internal management.

“With HMC, Harvard gets better results with lower costs,” Daniel says.

“When we manage assets internally, we have a much better sense of our risk. We know exactly where all of our positions are at all times,” Meyer says.

In fact, Harvard officials estimate that HMC is only about half as expensive as hiring outside money managers.

“We’re confident that over the last five years, it has cost Harvard half of what it would have cost had we used external managers and achieved identical results,” Meyer says.

But despite HMC’s stellar performance, conflict has arisen over compensation packages paid to HMC’s top investors—last year HMC’s highest paid investor earned $16.7 million, while Harvard President Neil L. Rudenstine earned a mere $350,000.

But Harvard officials and industry experts say such compensation is necessary if Harvard continues with HMC.

“If you’re going to invest internally, you want to make sure you have the best investors you can get. You’re competing in their business not yours,” says Eve Guernsey, J.P. Morgan’s managing director of institutional investing.

And because of its size, Harvard can afford to pay its money managers competitive industry salaries, a critical element to maintaining the best managers.

“A place like Harvard has the ability to offer compensation levels that are comparable to regular investment firms,” Sperling says.

Harvard’s compensation packages are more demanding than the average Wall Street package, officials say, since performance is based on only growth above HMC’s benchmarks, not overall growth.

Partly because they are more rigorous, the compensation packages are lower overall than those in the private sector. When Sperling departed in 1994 for the Thomas H. Lee investment firm; he cited compensation as an “important element” in his decision to leave HMC.

The controversy surrounding HMC’s compensation levels has mostly dried up, though, as HMC’s results have continued to skyrocket.

“You have to remember that if Jon [Jacobson] makes $5 million in a year, that means he’s added something like $500 million to the endowment,” Daniel says.

Looking Outward

But for some of HMC’s investors, the millions are not enough. It was “almost by accident,” Meyer says, that the University began outsourcing some of its investment portfolios in the mid-1990s.

“As people leave, if we think they’re good, we try to continue our relationship,” Daniel says.

HMC officials say Jon Jacobson, one of HMC’s top investors, was just too good to lose. In his final year at HMC, Jacobson’s fund saw a return of 42.4 percent—solidly outperforming the S&P 500 benchmark rise of 34.7 percent.

So when he left in 1998 to help found a new hedge fund, Highfields Capital Management, he took with him $500 million from HMC and raised $1 billion in outside money.

“To have Jon surpass the benchmarks by [8 percent] each year that he’s at Harvard is truly unusual performance,” Daniel says.

Later in 1998, the Harvard Private Capital Group, which had been overseen by Eisenson—spun off as Charlesbank Capital Partners, and took with it $1.4 billion from HMC.

At HMC’s inception, the company oversaw 90 percent of the endowment internally. Currently, that number stands at about 65 percent, and Meyer and Daniel speculate that it could drop as low as 50 percent within the next 20 years.

“We’re pretty happy where we are right now,” Meyer says.

A Global Endowment

Harvard’s endowment is spread out among hundreds of companies, thousands of acres of real estate and dozens of start-ups. The list of companies that HMC invests in runs the gamut from 160 shares of Martha Stewart Living to 877,000 shares of Exxon Mobil, HMC filings show.

And there are billions more that Harvard spreads out among select external managers, primarily Charlesbank and Highfields Capital, which now manages almost $2 billion, according to SEC filings.

Meyer says that he’s quite happy with the performance of HMC’s outside managers but that HMC could pull out of these investments at any time, should the University “lose confidence in their ability to add value.”

In the last two years, HMC has benefited from unprecedented returns in venture capital—which is largely responsible for last year’s $4.8 billion endowment increase last year. HMC’s investments in venture capital returned 413 percent last year, Meyer says.

“Harvard has benefited enormously from a once-in-20-year return,” says Professor Richard C. Marston of the Wharton School for Business.

But the risk involved in such investments can only be stomached by a large endowment, Marston says.

“An ordinary endowment could not follow the same kind of strategy,” he says.

Industry experts say Harvard’s endowment is large enough to balance the risk of large investments in venture capital with other “alternative assets.”

“Something that’s risky is not always imprudent. These investments are certainly prudent,” Manning says.

“When you look at them individually, they may look risky, but you need to look at them in the context of the whole portfolio,” Meyer says. “We’re pretty happy where we are right now.”

Investing Responsibly

HMC is given great freedom to invest the University’s endowment. But it is a freedom that does not come without caveat. Harvard’s investments in companies like Avenue Entertainment and various tobacco companies have drawn widespread attention to the ethics of HMC’s investments.

The only legal standard for university investing was set out in the “prudent man rule,” established in the 1830 case of Harvard College v. Amory.

The case required trustees of the University to “exercise judgment and care” which “men of prudence, discretion, and intelligence” would exercise in the management of their own finances. Trustees must also balance probable income and probable risk of the endowment capital.

Legal jargon aside, HMC has had to weigh its financial interests against its moral obligation to represent Harvard in the public eye.

Former president Nathan M. Pusey ’28 established the University’s first committee on shareholder responsibility after a controversy over Harvard’s stock in General Motors company in 1970—the first such “shareholder responsibility” campaign in the country.

Pusey concluded that Harvard’s aim should be to play the role of “good citizens in the conduct of [their] business,” and not invest in companies that violated “fundamental and widely shared ethical principles.”

In response to protests over Harvard’s investments in Gulf Oil and involvement in Angola in 1972, Harvard established the Advisory Committee on Shareholder Responsibility (ASCR) and the Harvard Corporation Committee on Shareholder Responsibility (CCSR) to make proxy decisions for the University on shareholder responsibility.

Those decisions are influenced heavily by established precedent according to Benjamin D. Tolchin ’01, who served as the undergraduate representative on the ASCR for the past two years after being selected by the Undergraduate Council.

CCSR and ACSR members are each assigned several resolutions to research and present at the meetings, before the committee debates whether to support a resolution.

In only 18 of 108 proxy votes last year did the CCSR go against the ASCR’s recommendation, even though a prohibition against investment in the tobacco industry is the only blanket policy that has been set out by both ASCR and CCSR.

“We try to influence the process rather than walk away. Once you walk away you have no influence,” Daniel says, citing Harvard’s pullout of investment in South Africa during apartheid during the 1980s.

When Desmond Tutu approached Harvard after apartheid ended to ask for help pressuring companies to reinvest in South Africa, the University had sold all of the stock in companies that did business with South Africa.

“The University as a shareholder had no influence anymore, that was the irony,” Daniel recounts.

A stickier situation, Daniel says, is when the University discovers that an external manager has invested money in questionable businesses—especially when the University learns of the investment after the fact.

“Our choice is awkward and difficult. If we don’t like something that Hedge Fund X has money in, we have very few choices,” Daniel says. “If you walk away from someone who has terrific returns for Harvard, that’s not an easy decision to make. If you walk away from an investor like that, you don’t get back in.”

“We have to keep in mind our key mission here is to earn money for Harvard,” Meyer says.

Overall, Harvard’s model for socially responsible investing and openness is an industry leader, says Simon C. Billenness, a senior analyst at Trillium, the nation’s largest socially responsible investment firm.

But Griswold says that the Commonfund has seen a drop-off in shareholder responsibility issues in the 1990s, since no single issue dominates anymore, as apartheid did in the 1980s—now concerns are spread more widely over tobacco, alcohol, child and slave labor, and weapons production.

“There’s no one at the barricades right now,” Griswold says.

Plus, after a decade of mergers, more conglomerates operate subsidiaries in a wide variety of industries.

“Part of the problem is that there isn’t one single issue anymore to screen for,” Griswold says. “None of them are snow white, they’re more like the seven dwarfs.”

With globalization and consolidation likely to continue, HMC is unlikely to avoid controversy entirely—but the University seems just as likely to overlook the occasional blow-up as long as the money keeps coming in.

“For Harvard’s perspective, the most important thing has always been the highest rate of return,” Sperling says.

—Staff writer Garrett M. Graff can be reached at ggraff@fas.harvard.edu.