Finding the Path to Growth

When Jack R. Meyer departs Harvard to start his own investment firm in the coming months, he will enter the market with a track record that’s sure to have investors lining up to hire him.

After fifteen years at the helm of the Harvard Management Company (HMC), Meyer is bequeathing his successor an endowment that makes Harvard the second wealthiest nonprofit in the world, with a net worth larger than some countries.

But as the endowment has multiplied many times over, so too have the challenges of managing the behemoth.

For the University, the selection of Meyer’s successor is inextricably linked to the question of whether Harvard should continue its unique in-house management structure, one in which HMC invests a substantial portion of Harvard’s money itself.

While HMC’s internal structure affords it better control over the risks it takes at a lower price, at times the in-house approach exposes Harvard to searing public scrutiny, and HMC has had difficulty retaining top managers at below-market wages.

The alternative is external management, in which most investment responsibility is outsourced to other firms, but this structure skirts these issues, perhaps at the cost of lower performance and higher management fees.

“It’s difficult to say which [structure] is more successful,” says John Griswold, executive director of the Commonfund Institute, the research arm of a group that manages money for over 1,400 nonprofit organizations.

When seven members of the Class of 1969 sent a letter in December 2003 attacking the compensation of managers—at the end of a year in which two Harvard bond traders earned over $34 million—they set off a public relations war about Harvard’s endowment management that played out in the country’s biggest newspapers.

Meyer defends the compensation system but notes that it is less generous than most private sector firms, thus making it harder to attract managers. And HMC’s troubles may only increase with the cap on maximum compensation set by its board in March 2004.

After a year under an unusually harsh public spotlight, Meyer announced he would step down in January, taking four other HMC investors—including the two well-paid traders—with him.

“It would be nice to drop out of the public spotlight a little bit,” Meyer told The Crimson in January. “Everything Harvard does is closely scrutinized.”

Without a doubt, Meyer’s departure is the end of an era for HMC.

Treasurer James F. Rothenberg indicated at the time that no option—including a move toward external fund management, which most universities use—is off the table for Harvard.

Even as it has defended its in-house system, over the last few years Harvard has quietly moved to a system that is half externally-managed as fund managers have spun off.

With the rapid departure of top personnel over the past few years, Harvard might continue to move toward a more externally managed system without eliminating the management company entirely.

ON THE TABLE

A several-year exodus of fund managers, culminating in the impending departure of Meyer and his partners, has raised questions about the sustainability of Harvard’s in-house management structure—an issue Meyer says is often discussed by HMC’s board.

While HMC handles its investments with an internal, 175-person staff, most universities and colleges—including Yale, Princeton, and Stanford—largely rely on outside managers to invest their endowments.

When Meyer took the helm of HMC in 1990, about 80 percent of Harvard’s investments were managed in-house. Today, that figure is closer to 50 percent.

The subject of HMC’s management strategy has come to a head in the past. The ballooning growth of Harvard’s endowment to surpass $10 billion in 1997, Meyer says, prompted the board to review HMC’s structure to determine whether a restructuring or outsourcing was needed. In the end, Harvard elected to maintain its in-house investment outfit because the board determined that, even with its problems, HMC was still the most practical group to manage the endowment.

But the transition to a new investment chief has once again highlighted the longstanding debate over what structure best advances the University’s endowment management goals.

In a January letter to alumni, Rothenberg, the steering committee’s chair, called the transition a time to “reflect on aspects of the distinctive investment model” that HMC has put to work for Harvard.

And in an interview with The Crimson at the time, Rothenberg would not rule out a move to completely external management, calling it “another possibility for the steering committee to look at.”

“Harvard certainly should retain, at a minimum, many elements of the system Jack has created,” says Jeffrey B. Larson, a former HMC manager who left to start his own hedge fund.

For now, members of the selection committee say that final decisions on the structure of HMC will be left for the new management company chief.

“Although we continue to discuss these questions, as does the Harvard Management Company Board, we have made a deliberate choice not to make decisions, but to leave them for the new CEO,” Vice President for Finance Ann E. Berman writes in an e-mail.

But the selection committee, tasked at least initially with a more fundamental examination of Harvard’s investment structure, may wield great influence over the future of HMC by its choice of a new leader.

Meyer says that his successor will have a number of options for the direction to take Harvard’s endowment. One possibility, he says, is that the new CEO could choose to maintain internal management for some assets, but increase the use of outside managers, changing the mix from 50 percent invested externally to, say, 65 percent. Another potential choice facing the CEO is for Harvard to invest securities through hedge funds via external managers but focus its in-house efforts on asset classes like timber.

“The mix could change a little bit,” Meyer says.

HMC’s new chief could also select the opposite route, driving up the proportion of funds managed in-house.

“It is possible, of course, that the new CEO will come in and say, ‘I want to rebuild this [internally], it makes a lot of sense here at Harvard,’ and the ratio actually increases,” he says.

Despite the avalanche of departures from HMC, Meyer says that the current mix of internal and external management could also be maintained if the firm’s leadership believes that route is practical.

And Meyer cautions against premature speculation about what structural changes his successor will implement, noting that upon his arrival at HMC in 1990 he had a history of externally managing funds at previous jobs but embraced the internal model at HMC.

“I know people here at HMC thought [a shift to external management] was going to happen...and maybe even the board thought that was going to happen too,” he says. “I came here and I saw things that were happening internally that were just great and we nurtured those strategies.”

Meyer says for several years the percentage of the endowment invested internally rose from 80 to 85 percent before declining as managers left the company.

“It’s a little bit like the Supreme Court justices,” he says. “You’re never too sure how they’re going to behave when they actually get on the bench.”

OUTSOURCING THE ENDOWMENT

Moving to an externally managed structure would shield the University from the scrutiny it currently faces over managers’ salaries.

But competition for high quality external managers mean that their fees are much higher than the relatively low compensation Harvard grants its internal staff.

According to Meyer, hedge funds, a common form of external management, charge an average of 1.5 percent in annual management fees plus 20 percent of profits. HMC, on the other hand, gets the job done while charging a base fee of 0.26 percent plus incentives—which can be positive or negative. Thus, Meyer estimates that Harvard would have paid roughly twice as much over the past 10 years to achieve the same returns on the endowment using external management.

And the investment chiefs of such firms have to “manage managers” rather than securities, Griswold says.

Having managed both assets and managers, Meyer calls the latter more of a “different skill set” than a challenge.

For Harvard, the chief disadvantage to external management could be decreased performance, because some top-tier external managers only permit each investor to invest a few million dollars. This means that Harvard would have to work with scores of different investors to manage its billions.

The same is true of private equity and external hedge funds, Meyer adds. As a result, Harvard’s size could mean that once it has exhausted investment opportunities with top-tier firms, it has “to go down the quality spectrum [of firms], which is very dangerous,” according to Meyer.

While Yale has also achieved impressive returns using outside management, Meyer says size is far less of a problem for the Bulldogs. Yale has the second-largest university endowment at $12.7 billion, but it pales in comparison to Harvard’s $22.6 billion. For Harvard, Meyer says, increased competition for external funds has ensured that achieving Harvard’s current performance under a fully external system would be “very difficult.”

IN THE HOUSE

For Harvard, internal management skirts the problems of securing enough high-quality outsiders to handle the endowment, and also provides for greater control over risks, more effective financing, and more efficient use of capital, Meyer says.

But Harvard’s internal system is not without its headaches.

By July 2004, five fund managers had left HMC in six years to strike out on their own.

Along with the constant threat of losing managers to better-paid positions at outside hedge funds, in-house endowment management at Harvard is “enormously complicated,” Meyer says, requiring an operations staff that is much more sophisticated than the average hedge fund.

“People look in at the endowment portfolio, and it’s a little scary from the outside because there are a lot of complicated strategies going on,” Meyer says.

Another factor that may have drawn away managers from HMC is the visibility of Harvard’s endowment. Because it is owned by a nonprofit, HMC must report the salaries of its highest-paid employees, so the details of top managers’ compensation are openly available.

Public knowledge of compensation has bothered many top managers at HMC, according to Meyer. This stands in stark contrast to private investment firms, where compensation is not disclosed.

And while higher, and confidential, pay scales can be found outside of HMC—“I don’t think anyone has left because we’ve paid them too much,” Meyer jokes—he says that the opportunity to start one’s own firm, rather than greater compensation, is the chief reason for managers’ departures.

The financial environment of the early 1990s provided HMC with a natural advantage in attracting managers. At the time, it was difficult to raise money and get the structure in place to start a hedge fund, so managers leapt at the opportunity to develop a track record at HMC, Meyer says.

And to many fund managers, Harvard’s endowment was more than just another hedge fund.

“People worked at Harvard Management because they felt that causing Harvard endowment assets to grow was a noble pursuit,” says Byron R. Wien ’54, a managing director and senior investment strategist at Morgan Stanley. “It was a great way to spend your life.”

But since then, the environment has changed, and it is much easier for new firms to raise capital today. As a result, some managers have left to start their own funds.

After nearly 13 years at HMC, Larson says he “felt that I had one more challenge left in my life for what I wanted to do. Now’s the time to hang out my own shingle.”

HMC has further incentivized the departure of its fund managers by supporting those who strike out on their own: roughly a quarter of the current endowment is invested by outside managers who “spun out” of HMC.

For example, when Larson left with 14 members of his team in July 2004, the University invested $500 million on the launch of his newly-formed fund.

But despite the potential rewards of leaving HMC, Meyer says that in 1990, when he began work, he could not have predicted the staff departures.

“We didn’t hire these people with the intent that they would leave,” he says. “I wish they were all here today.”

He says he also failed to anticipate that managers would leave with their entire teams when they founded new firms—something he says “makes perfect sense” to him today.

“On the other hand I’m not sure there’s much we could have done about it,” he says. “The environment’s changed, and it’s just harder to attract people and retain them here now than it used to be.”

COMPENSATION UNDER FIRE

The University’s consideration of external management comes on the heels of a year in which the University found itself under attack for the salaries it paid its top managers, even though other universities likely pay similar—but largely undisclosed—fees.

The original Class of 1969 letter and subsequent follow-up spawned a flurry of media attention, including articles in national newspapers like the New York Times and the Wall Street Journal.

“It’s not a fun thing to have compensation listed publicly,” Meyer says. “Nobody here at HMC likes to have their compensation in the paper.”

The debate has focused attention on the bonuses earned by HMC’s fund managers, who have seen their compensation rise as the endowment continues to yield staggering returns.

Meyer, who designed HMC’s compensation system, believes it is sound. On top of a base salary around $400,000, the incentive-based system provides managers with bonuses when they outperform their benchmarks.

But the criticism became a thorn in the side of University President Lawrence H. Summers and other top Harvard administrators. D. Ronald Daniel, then Harvard’s treasurer, and Donella M. Rapier, vice president for alumni affairs and development, both wrote letters defending the University’s compensation policies.

Nonetheless, after public pressure and the announcement of annual salaries that soared to record highs after a successful year, Harvard capped maximum compensation for fund managers in March 2004.

William A. Strauss ’69, an alumni who signed the letter, dismisses the assertion that Harvard is cutting costs by managing its endowment internally.

“We don’t know that,” Strauss says. “It’s not cast out for competitive bid.”

But other observers argue that Harvard’s managers aren’t being paid enough.

“You have to compensate them fully,” says Paul J. Zofnass ’69, president of the Environmental Financial Consulting Group, Inc. “You can’t assume that just your name alone will get people to want to work for you.”

Meyer says he is not confident that an academic setting can retain “world-class” portfolio managers, given what the culture of a university is willing to accept.

And finding a solution that ensures both high returns and an acceptable structure for the University and its public image is vital as the endowment and the projects it funds continue to grow.

In the last few years, the University has announced a number of major initiatives that will depend on Harvard’s continuing financial success.

The construction of a new campus in Allston is likely to cost billions. Stem cell research, a promising new field that top administrators are committed to pursuing, must be funded solely through private sources according to federal law. And even smaller long-term initiatives, such as increasing financial aid and the recently-announced plan to spend $50 million to increase diversity, rely on steady endowment growth.

Many at Harvard are more focused on these ambitious plans, but their success may hinge on the selection of a new management company leader—and the structure within which it will invest the University’s endowment.

And while the size of Harvard’s nest egg may present a plethora of investment challenges, one thing is certain, according to Ann E. Kaplan, who is director of the Voluntary Support of Education Survey at the Council for the Aid to Education.

“One of the benefits of having a large endowment is that you can draw upon it when needed,” she says.

—Staff writer Alexander H. Greeley can be reached at agreeley@fas.harvard.edu. —Staff writer Nicholas M. Ciarelli can be reached at ciarelli@fas.harvard.edu.