ALTERNATIVE INVESTMENTS - Making the Grade
After a bear-market rush into alternatives, college endowments are scrambling for talented portfolio managers.
On May 31, in a stunning move, Lehigh University announced that Peter Gilbert would become the school’s first chief investment officer. With high turnover at endowments and numerous U.S. colleges and universities seeking CIOs, securing one of the world’s savviest and most innovative investors was a major coup.
Gilbert, who had headed up the $35 billion Pennsylvania State Employees’ Retirement System for 14 years, is known for pushing the investment management envelope; at PennSERS he had $9 billion invested in hedge funds. His experience with alternative assets was a major attraction for the Lehigh board of trustees, which has ultimate oversight responsibility for the endowment and its current $90 million hedge fund portfolio.
Universities like Lehigh often entrust the management of their endowments to investment committees run by alumni volunteers. Such committees are tasked with myriad duties, including manager searches, portfolio construction and asset allocation decisions. In Lehigh’s case, the investment committee managed the school’s endowment for a quarter century without help from dedicated staff or consultants.
But as the fund -- ranked No. 70 in size among U.S. endowments in the 2006 survey by the National Association of College and University Business Officers (Nacubo) in Washington, D.C. -- approached $1 billion in assets, Lehigh’s board knew it had a potential problem on its hands. Board members were concerned about the increasing complexity of Lehigh’s portfolio, which in the past five years has added a variety of alternative investments, including hedge funds, distressed debt, private equity and opportunistic real estate.
“All of us were finding it difficult to make the time to do all these things and still do our day jobs,” says R. Charles Tschampion, chairman of the Lehigh investment committee since 1999 and a former senior executive at General Motors Investment Management Corp. in New York. “With the complexity of the market and the amount of oversight necessary to deal with existing managers, as well as keep up with the growing number of strategies and possibilities in the marketplace, we could no longer rely on a volunteer committee.”
The challenges faced by Lehigh’s board and investment committee have become altogether too common, as hedge funds and other alternative assets are now a standard component of most college and university portfolios. Many of these schools got into this situation by trying to emulate the biggest U.S. endowments -- in particular those of Harvard University and Yale University -- which have long used alternatives to diversify their portfolios and boost returns. But finding investment talent to manage such complex portfolios is not easy. Retaining that talent is even harder.
“If your goal is to achieve optimized risk-adjusted returns through diversification into alternative assets like hedge funds, it is essential to have professionals with specialized expertise making your investment decisions,” says Michael McCaffery, CEO of Makena Capital Management in Menlo Park, California. As CEO of the Stanford Management Co., the now-54-year-old McCaffery managed Stanford University’s $14 billion endowment for six years before leaving in 2006 to found Makena.
Schools with less than $1 billion in assets generally choose one of two paths: turn to consultants like Cambridge Associates to advise them, or entirely outsource the management of their funds to specialized investment firms set up by former endowment chiefs like McCaffery. Neither solution is cheap. Consulting firms get about 0.5 percent of assets for their services, whereas outsourced investment firms typically charge both management and incentive fees.
Even for large endowments that can afford to hire a dedicated CIO and staff an investment office, finding and retaining talented professionals is no small feat. Lehigh hired executive recruiting firm Russell Reynolds Associates to help with its CIO search, which took nine months and involved interviews with eight candidates, first in New York and then at its Bethlehem, Pennsylvania, campus, before the school decided on PennSERS’ Gilbert.
“We wanted somebody who would respect the stature of Lehigh,” says Tschampion, who co-chaired the search committee with Denise Blew, treasurer for Lehigh’s board of trustees.
Along with Lehigh, about a dozen institutions have created investment offices in the past two years, including Boston University and Williams College. “It used to be that if you had $500 million to $1 billion, you would seriously consider having your own CIO and probably three or four staff members,” says Jack Meyer, 62, who managed Harvard’s endowment for 15 years before leaving to start his own hedge fund firm two years ago. “That number has probably moved up to $1 billion because the overhead has gotten more expensive.”
The importance of university endowments has never been greater. In 2002, 40 U.S. universities had endowment funds with more than $1 billion in assets; when Nacubo releases its figures for 2007 later this year, there will be more than 70. An additional 150 schools will have $250 million to $1 billion in assets. As the competition for top students and professors increases, schools of all sizes are increasingly relying on the investment returns from their endowments to help fund scholarships, pay salaries and make capital improvements. Lehigh, for example, used endowment earnings to cover $43 million, or 12.3 percent, of its $350 million operating budget for the fiscal year ended June 2007. That’s up from 1999, when the endowment covered $22 million, or 10 percent, of Lehigh’s then $220 million in operating expenses.
Given the growing complexity of endowment portfolios, trustees are worried about blowups like last year’s collapse of hedge fund Amaranth Advisors, a Greenwich, Connecticut°©based multistrategy firm that lost more than $6 billion on an oversized bet on natural gas. The year before, DePauw University in Greencastle, Indiana, lost most of its $3.25 million investment in Bayou Management, a Stamford, Connecticut°©based hedge fund firm whose principals later admitted to producing false financial statements to cover up losses. In 2001 the Art Institute of Chicago lost its $22.5 million investment with Integral Investment Management when the Dallas-based firm lost about 90 percent of its assets trading index options but did not accurately report the losses for six months.
Yet many hedge funds lose money simply because their intricate strategies go awry. That was the case in 1998 for Miami-based emerging markets manager Everest Capital, which got caught in the Russian bond default and lost about half of its $2.5 billion fund. Three years earlier, Dickinson College, a small liberal arts school in Carlisle, Pennsylvania, had invested 1 percent of its endowment in Everest. The now°©$242 million endowment lost $1.5 million in Everest, spurring Dickinson treasurer Annette Parker and the board to revamp the school’s investment committee."The change in governance structure was critical to our success,” says Parker.
The rush into alternatives by endowments began in earnest when the bull market came to a crashing halt in 2000. The 556 institutions that reported to Nacubo for the fiscal year ended June 30, 2002, suffered a total loss of $14 billion, with the typical endowment falling 6 percent from the previous year. The biggest endowments -- those with more than $1 billion in assets -- lost on average just 3.8 percent. Harvard fell a minuscule 0.5 percent, while its longtime rival, Yale, actually finished in the black, up 0.7 percent for fiscal 2002. In one stroke, the two-class system of endowment investing was exposed, and the race to catch up was officially on.
“Most committees met and said, ‘We want to look like Harvard and Yale,’” says John Griswold, executive director of the Commonfund Institute, the research arm of the Wilton, Connecticut°©based Commonfund Group, which manages more than $42 billion for some 1,800 endowments and other institutions. “But it’s not that easy. The problem is much more complex than most people realized.”
Complex indeed. According to the 2007 Commonfund Benchmarks Study of Educational Endowments -- which is based on investment data from 741 institutions -- U.S. universities and colleges have, on average, 39 percent of their endowment portfolios in alternative investments, including 18 percent in hedge funds. That’s up from 24 percent in alternatives and 7 percent in hedge funds in 2001, the first year the Commonfund did its study.
Investment staffing has not kept pace. For the past three years, the typical endowment has had to get by with just one full-time staff person, according to the Commonfund study. Endowment funds with more than $1 billion in assets employ an average of 10.7 people, down from 12.5 in 2004. “Staffing is a stealth issue,” says Griswold. “Very few schools have the people to manage these managers.”
Top CIOs at many endowments have been heading for the doors -- often to set up asset management firms with their key staff in tow -- exacerbating the CIO crunch. “We are aware of close to 100 CIO and senior staff searches and changes that have occurred between February 2005 and June 2007,” notes Sandra Urie, CEO of Cambridge Associates in Boston. A typical CIO at a $1 billion°©plus endowment makes a base salary of $300,000 to $600,000, plus a bonus of 50 to 100 percent. That’s outstanding by university standards, but similar jobs at family offices, funds of hedge funds and other investment management firms can be far more lucrative."There’s more competition for investment talent coming from organizations such as funds of funds,” says Urie. “Some CIOs have left to join those businesses or have launched their own.”
Mark Yusko of the University of North Carolina and Bob Boldt, from the University of Texas, each left over disagreements with their boards, or what Yusko calls the four Ps -- policies, procedures, personalities and politics. Salary hassles at Harvard helped push Meyer out the door in 2005. “A willful person on the board can make your life just as miserable at a $600 million endowment as at a $6 billion pension plan,” says Churchill Franklin, former chairman of the board, and now emeritus trustee, at Vermont’s Middlebury College, which has a $782 million endowment.
The decision whether to outsource investment duties, set up an internal investment office or rely on a consultant can be as much about the personalities on the board as it is about asset size, says Franklin, who is also an executive vice president of Acadian Asset Management in Boston. At Dickinson the board last year chose to outsource management of its endowment to Investure, a Charlottesville, Virginia°©based firm founded by Alice Handy. Dickinson’s board was attracted to the idea of being part of a consortium of schools managed by the former investment chief of the University of Virginia endowment. “Alice Handy is our CIO,” says Parker. “We’re now part of a $4.5 billion portfolio.”
Even for bigger schools with well-established investment offices, finding a new CIO can be a long process. In July 2006, William Spitz announced that he would be stepping down as CIO at Vanderbilt University in Nashville, Tennessee. Eleven months later the school named as his successor Matthew Wright, the former director of investments at Atlanta’s Emory University, which has a $4.9 billion endowment. Spitz, who helped grow Vanderbilt’s endowment fund from $300 million to $3.4 billion over two decades, says Wright will have his hands full managing a portfolio that has more than half of its assets in alternatives, including $734 million in hedge funds.
For most of their history, university endowments were managed conservatively, investing in stocks and bonds, sometimes by an outside adviser and often without great skill. In the late 1960s, Yale’s trustees contracted out management of the school’s endowment to a Boston-based money manager, Endowment Management & Research Corp. On its watch, between 1969 and 1979, the inflation-adjusted value of Yale’s endowment dropped by 46 percent, representative of the dismal returns experienced by many schools throughout the 1970s. Then David Swensen showed up. Since he took the helm of Yale’s $1 billion endowment in 1985 at the urging of his former Ph.D. adviser, Nobel Prize°©winning economist James Tobin, Swensen has continually ventured into new asset classes and new allocation models before others even thought -- or dared -- to. The Yale CIO was the first institutional investor to recognize the value of what he calls absolute-return investments -- hedge fund strategies like merger or convertible arbitrage that are expected to produce equity-like returns with a low correlation to stock and bond markets. By 1994, Swensen had invested 20 percent of Yale’s assets in them. That same year, other big endowments had an average of 5.2 percent of their portfolios in hedge funds; the typical endowment had on average less than 2 percent.
Swensen’s core investment principles include a strong belief in equities (both public and private), portfolio diversification and exploiting less efficient markets. He also believes in using outside managers and negotiating fee structures with them that align their interests with those of Yale. Swensen has all but abandoned bonds, reducing them to just 4 percent of the portfolio. Only 16 percent of the endowment is invested in U.S. marketable securities, down from more than 70 percent when Swensen started. The other 84 percent of Yale’s portfolio is allocated to foreign equity, private equity, absolute return and real assets like timber, gas and oil. By the end of fiscal year 2006, the $18 billion endowment had an annualized return of 16.3 percent during Swensen’s tenure.
Swensen’s closest rival during the past two decades was former Harvard Management Co. head Jack Meyer, who delivered a 15.9 percent annualized return managing Harvard’s now°©$30 billion endowment from 1990 through 2005. In fact, it was Swensen who recommended that Harvard hire Meyer, then treasurer and CIO of the Rockefeller Foundation in New York.
Although Meyer and Swensen are both big believers in alternatives, their approaches to endowment management are markedly different. At Yale, Swensen employs about 25 investment professionals, whose job it is to oversee more than 100 external managers, including hedge funds. Under Meyer, Harvard operated like a hedge fund; about half its assets were invested internally by a staff of 170 professionals.
The biggest difference between the two schools has been the very public scrutiny and criticism that Meyer endured over the salaries paid to the HMC team. Unlike Yale, where Swensen had a salary of $1.3 million in 2006 -- modest by Wall Street standards -- Harvard routinely paid its top investment professionals more in line with what they could earn in the private sector. In the mid-'90s, U.S. equity manager Jonathan Jacobson generated headlines in Boston because the $5 million to $7 million a year he earned was many multiples of what Harvard’s most esteemed professors earned. In 2001 three HMC managers had salaries topping $10 million, including foreign equities expert Jeffrey Larson, who made $14.8 million.
But even those salaries were not enough to keep investment stars at Harvard. Jacobson left in 1998 to start Highfields Capital Management, a now°©$10 billion hedge fund firm in Boston that began with $500 million of HMC capital. Other managers also left to launch hedge funds -- all in Boston -- including Larson, founder of Sowood Capital Management, which had $3 billion in assets when this summer began. At the end of July, Larson announced that Sowood would be closing its doors after suffering heavy losses on its credit-related positions amounting to more than 50 percent of its assets.
Meyer himself departed Harvard in September 2005, taking with him 33 staff members to start Convexity Capital, a now°©$6.4 billion hedge fund firm. About 95 percent of Convexity’s investors are foundations and endowments. Harvard tapped Mohamed El-Erian, a top fund manager at fixed-income behemoth Pacific Investment Management Co., to take over Meyer’s spot.
Swensen’s disciples have chosen a different path: endowment management. Andrew Golden left Yale in 1995 to manage the endowment at Princeton University, D. Ellen Shuman went to Carnegie Corp. in 1999, and Seth Alexander joined the Massachusetts Institute of Technology in 2006. In 2000, Bowdoin College, a small liberal arts school in Brunswick, Maine, with about 1,700 students, hired Yale’s Paula Volent, first as associate treasurer, then in 2002 promoted her to the newly created position of senior vice president for investments. Bowdoin’s then°©$450 million fund has grown to $673 million since she took charge.
As endowments attempt to imitate the Swensen model, they have a ready blueprint to follow -- a 25-page Harvard Business School case study on the Yale University Investments Office. The report, which was originally written in 1995 and last revised in May, outlines in great detail how Yale constructs its portfolio. Still, smaller endowment funds typically don’t have access to all the same asset classes. Instead, they load up on the one alternative that has made itself available to everyone -- hedge funds. At endowments with less than $100 million in assets, hedge funds account for three quarters of their total alternative allocation, according to the Commonfund survey. These funds have, on average, 8.9 percent of their portfolios in alternatives. More alarming is the fact that last year 76 percent of hedge fund assets in endowment portfolios with $51 million to $100 million in assets were invested, on average, in just four single-manager hedge funds -- going against Swensen’s key principle of diversification.
Traditionally, investment committees turned to consultants for help. This was the case back in 1982, when Dickinson College engaged Cambridge Associates, which today counts 600 endowments among its 800 clients. Cambridge was instrumental in introducing small endowments to hedge funds; by the mid-1990s it became fairly common for endowments of all sizes to launch small, starter hedge fund portfolios. It was Cambridge that advised Dickinson to invest in Everest.
After the Everest loss, Parker took on oversight of Dickinson’s then°©$151 million endowment in 1999 following a change in leadership on the board of trustees and the arrival of a new school president. She and then°©investment committee chairman Marc Stern requested a more proactive team from Cambridge to assist the committee in portfolio management duties. Parker recognized the need to strengthen the investment committee and worked with Stern to restructure it. Borrowing an idea from Williams College, they set up subcommittees to focus on different asset classes, tapping trustees and alumni with expertise in areas like distressed debt and hedge funds to sit on them.
With Cambridge’s help, by 2005, Dickinson had a total of six hedge funds in its hedge fund portfolio, which had grown to 30 percent of assets. The school removed Everest in 2002. (To its credit, Everest did not shut down after its 1998 losses and has since rebounded. It was up more than 100 percent in 2003 and today manages about $2.2 billion in assets.)
Dickinson also made allocations to distressed debt, emerging markets and other alternatives. The hard work paid off. For fiscal year 2005, Dickinson’s endowment grew by 29.8 percent, adding $56.3 million to its net assets and ranking it 16th in percentage asset growth out of 742 colleges and universities followed by Nacubo.
Despite Dickinson’s success, Parker was concerned that the fund was becoming too complex for her and her associate treasurer to handle alone, so they began to explore other investment options. “We weren’t displeased with Cambridge, but we had moved beyond that model,” says the 1973 Phi Beta Kappa alum with a BA in fine arts and art history. (She earned an MBA in accounting from Pennsylvania’s Shippensburg University in 1987, a year before joining Dickinson as associate treasurer.) “Consultants aren’t enough.”
The board of trustees decided that hiring an in-house CIO should wait until the endowment reached $1 billion in assets and that outsourcing the CIO function was the best option. But they wanted a solution that would keep alumni like current board chairman Thomas Kalaris, CEO of Barclays Wealth Management in London, actively engaged with endowment activities.
Dickinson chose to go with Investure in May 2006. Handy, the firm’s founder and president, provides all the services of an in-house CIO, keeping her eye on the Dickinson portfolio on a daily basis and attending investment committee meetings. Investure also offers educational seminars and opportunities to share ideas with peers at its other endowment clients, which include Barnard College, Middlebury and Smith College. The focused, personalized attention that Investure provides limits the number of clients the firm will take on. With eight now, Handy says there’s room for just two more.
Scalability is not an issue at Makena Capital. On the team with founder McCaffery are ex°©Stanford Management colleagues David Burke and Michael Ross, as well as 12 other investment professionals. The firm offers a single, pooled endowment fund that looks very similar to the portfolios of the top 25 endowments and foundations. Makena is designed to provide all the investment needs faced by schools lacking a CIO: diversification, global investing and alternatives. The fund closed to new investors on July 1, with $10 billion in assets.
For Yusko, starting an outsourced endowment investment firm was more of a bittersweet affair. After a stint as the No. 2 investment officer at Notre Dame University, Yusko was hired by UNC in 1998 as its first dedicated CIO. He was excited about helping build UNC Management Co., which had responsibility for investing UNC’s then°©$707 million in endowment funds. While there, he grew UNC’s hedge fund portfolio from 7 percent to 55 percent of overall assets.
Yusko had a number of novel ideas, including extending his investment skills to outside clients -- particularly schools and foundations -- to garner additional revenue for UNC. He was initially given the green light by the board of trustees to pursue outside work, much as professors are permitted to take on consulting assignments, but when the new board chairman wanted to refocus on managing only UNC accounts, the board demanded that he stop taking outside money. Yusko instead resigned in April 2004 and opened Morgan Creek Capital Management in Chapel Hill, North Carolina, where he now manages $6 billion for mostly high-net-worth clients.
Like Yusko, Bob Boldt left the endowment world after a disagreement with his board of regents about how to run the investment management company. As CEO of Utimco, which manages the $13 billion endowment for the University of Texas System, Boldt had returned to his home state in 2002 with a vision of implementing an aggressive asset allocation plan that included increasing UT’s already sizable allocation to hedge funds. By last spring, Boldt had begun to lose the support of the board; he resigned on September 1, 2006.
Boldt is fundraising for his new outsourced endowment venture with New York°©based Perella Weinberg Partners. “I want to take the board out of the conundrum where they are asked to make decisions with limited information,” says Boldt, who will operate out of Austin, Texas. He believes that trustees should focus on strategic planning and leave the tactical investment decisions to the experts.
Nashville may not be known as a hotbed of investment management activity, but the country music capital of the world has proved to be a great place to run an endowment. There, William Spitz delivered a 13 percent annualized return in his 22 years managing the endowment at Vanderbilt University. In the process, he helped the school -- which is nestled on 330 acres just a five-minute drive from downtown Nashville -- amass a $3.4 billion portfolio with more than half its assets in alternative investments.
Like many endowment professionals, Spitz, 56, is an alumnus of the institution where he works. After graduating from Vanderbilt in 1973 with a BA in business administration and picking up an MBA from the University of Chicago the next year, Spitz went to work for several New York°©based asset managers before returning to his alma mater in November 1985 as head of the then°©$300 million endowment. “I wanted to do something different from both a career and a lifestyle viewpoint,” says Spitz, who teaches a finance course at Vanderbilt’s Owen Graduate School of Management.
But times have changed. The perks of a career spent within ivy-covered walls are disappearing as fast as a beer keg at a frat party. As the pressures of the corporate sector invade the halls of academe, the role of endowment chief is becoming much less attractive to potential candidates. For one thing, investment staff must travel all over the globe to vet managers. Portfolio complexities have done away with the six-week academic vacation. The increased scrutiny of endowment performance is perhaps the most difficult change to bear. “Every quarter we interact against 75 of our peers, and if we don’t have particularly good numbers, there’s inevitably someone asking why we didn’t do as well as Princeton,” explains Spitz.
Following the trail blazed by Swensen, Spitz has invested almost a quarter of the Vanderbilt portfolio with about 20 single-manager and multistrategy hedge funds. “I felt like I was taking some personal risk going into all these alternatives,” reveals Spitz, who had an investment team of just four professionals. “Now I think the reverse is true; if you don’t go into alternatives, your career is at risk.”
Spitz has written several articles and a book on investing. Last year he co-authored a Harvard Business School case study with HBS professor André Perold that examines the risks taken at the Vanderbilt endowment. He questions the logic behind building outsize hedge fund portfolios at many schools. “With 10,000 hedge funds now, you can’t imagine they can continue to provide the kind of performance they have,” Spitz reasons. “Some people are going to end up paying a lot of money for mediocre performance.”
The trustees at Lehigh hope to avoid that fate by hiring Gilbert, who had become a little restless after 14 years of running the Pennsylvania state pension fund. He had built the largest hedge fund portfolio of any state retirement system through a slow process of board education and trial and error.
“We’ve done a lot of innovative things here,” says Gilbert, speaking from PennSERS’ offices in the state capital of Harrisburg, about 90 miles west of Lehigh’s leafy campus, where he will take up residence this summer. Under Gilbert, Pennsylvania’s was one of the first pension plans to get into portable alpha, an investment strategy that uses derivatives to layer hedge fund returns onto a broad market index. PennSERS’ hedge fund portfolio has generated an impressive $780 million in excess returns since its January 2002 inception. With 14 investment professionals to help him at PennSERS -- one exclusively focused on the portable alpha program -- Gilbert saw the fund earn 16.4 percent in the year ending December 2006. But the difficulties of working in the public eye and the constant demands of explaining and justifying his investment ideas to a largely unsophisticated audience -- the pension board, plan members and retirees -- took their toll on the 60-year-old CIO.
“It seemed like maybe it was time to move on to a new career of sorts and a new challenge,” says Gilbert, who leaves a compounded annual return of 10.8 percent as a legacy of his tenure, during which time PennSERS paid out $18 billion to retirees.
Although Gilbert is taking a turn in his career path, he remains faithful to the not-for-profit sector. The 1969 Wesleyan University graduate worked for public social service agencies in the 1970s, earning a master’s degree in social work from Columbia University in 1976. By 1990, Gilbert was director of the mayor’s pension unit in the City of New York’s Department of Finance, before leaving in 1993 to become CIO of PennSERS.
Don’t try telling Gilbert that campus life is not all that it’s cracked up to be. “The emphasis on intellectual curiosity, learning, exploring new ideas -- I think that’s a very stimulating place to be,” asserts Gilbert, who says he is looking forward to the Dalai Lama’s visit to the Lehigh campus next year. Of course, it doesn’t hurt that Gilbert can expect a big pay increase in his new job from the $229,380 base salary and 25 percent bonus he earned at PennSERS in 2006.
Attracting marquee names like Gilbert to head endowments is going to be increasingly difficult. To be successful, an endowment CIO needs to have a sense of mission, as well as a tough skin.
“Universities are now very sensitive to their endowment returns, so to me this is not a job to retire into,” says former Harvard endowment chief Meyer. “The pressure is intense, and it’s measured in basis points. Every year the board is going to look to see what your return is relative to all your peer institutions -- and if you’re not measuring up, it’s not going to be fun.”