Hawaii’s scandal-plagued Kamehameha Schools boosted endowment returns but still struggles to diversify its property-heavy portfolio.

Many foundations begin life with big, often restrictive, grants from a donor; over time they must find ways to invest their riches wisely, diversifying their holdings to ensure that their missions are fulfilled for years to come. But few have had such a singular beginning -- or as controversial a management history -- as Hawaii’s Kamehameha Schools.

Formerly known as the Bernice Pauahi Bishop Estate, the Kamehameha Schools is a charitable trust set up by Princess Bernice Pauahi Bishop, the last descendant of King Kamehameha, who unified the islands in 1810. At her death in 1884, she bequeathed her property for the education of native Hawaiians and the preservation of their culture. Three years later a school for boys opened with 39 students; it was followed in 1894 by a girls’ school with 35 pupils.

Today the trust, which controls nearly a tenth of the state’s land, is an investment giant. With $7.7 billion in assets as of June 2006, Kamehameha would have placed seventh if it were ranked with university endowments, exceeded in size only by those of Harvard University, Yale University, Stanford University, the University of Texas, Princeton University and the Massachusetts Institute of Technology. Its portfolio returned about 20 percent in the fiscal year ended June 30, boosting its value to some $9 billion after expenditures, says chief investment officer Kirk Belsby.

Kamehameha spent $250 million in its latest fiscal year to educate 5,400 students at three kindergarten-to-12th-grade campuses -- one each on the islands of Oahu, Maui and Hawaii -- as well as to fund community outreach programs that offer prenatal care, subsidized preschools and college scholarships. Last year more than 20,000 native Hawaiians received support, a number the trust hopes to boost to 50,000 by 2015. There is no shortage of work to be done: Native Hawaiians rank at the bottom of most socioeconomic scales in the state; one in six lives in poverty.

“If we go out into the community, we can do a whole lot more,” says Kamehameha Schools CEO Dee Jay Mailer. “So that’s where we choose to devote a lot of our resources.”

But teaching children and preserving their cultural heritage has proven much easier than taking care of the trust’s assets. Secretive and immensely powerful -- as the state’s biggest landowner, the trust has long commanded wide influence in local politics -- Kamehameha a decade ago became a school for scandal.

During the 1990s the five trustees, appointed and overseen by the local judiciary and legally the owners of the estate, turned truant. Operating with little or no accountability, the five, who included a sitting speaker of the state House of Representatives and a former president of the state Senate, paid themselves each $900,000 a year and ran what the Internal Revenue Service dubbed “a personal investment club.” The trustees gave lucrative and often bogus contracts to friends and funneled hundreds of thousands of dollars to politicians, according to court documents. “They had a unit whose sole purpose was to control the politics of the state,” says Robert Watada, the recently retired executive director of the state Campaign Spending Commission. “They worked to get people elected and once they were in office, told them what to do.”

Ignoring advice from consultants at Cambridge Associates to diversify the portfolio, the trustees invested heavily in illiquid, private deals. One, a $500 million purchase of a 10 percent stake in Goldman, Sachs & Co. in the early 1990s, yielded billions. Many more, such as an investment in KDP Technologies, which ran a soft-corepornography Web site masquerading as an Internet dating service, were fiascos. The portfolio became dangerously unbalanced: Just two assets -- real estate and the Goldman Sachs stake -- made up some 70 percent of its value during much of the 1990s.

Eventually, to cover investment losses and boost their compensation, which was tied to returns, the trustees cut back on educational programs, triggering a revolt. In May 1997, angry students, parents and alumni cast aside their Hawaiian restraint and marched to the Honolulu offices of the Bishop Estate. Subsequently, the state attorney general alleged breaches of trust and petitioned for removal of the trustees; the IRS threatened in 1999 to strip the trust’s tax-exempt status and impose a $900 million fine unless the trustees were ousted.

A court appointed an interim board of trustees in May 1999 that reached agreement with the IRS on a package of governance reforms that moved the Bishop Estate closer to the best practices of not-for-profit corporations. The old trustees were forced out, and the new board limited its responsibilities to broad policy considerations, including asset allocation. Day-to-day management was entrusted to a CEO, a position also established in 1999 and filled by Mailer since 2004. In 2000 the trust’s name was changed from the Bishop Estate to Kamehameha Schools.

“Before, the trustees would dictate and everyone would do,” says Mailer, a Kamehameha Schools alumna and former COO of the Global Fund to Fight AIDS, Tuberculosis and Malaria, a private Swiss foundation. “Today they do not muck around in operational issues.”

Crucially, the trust adopted education and spending policies that, among other things, mandated more-diversified asset allocation as well as average annual disbursements of 4 percent of the value of the portfolio. Stronger financial management standards were put in place, including thorough recordkeeping and the use of generally accepted accounting principles. With the new accounting came a nasty surprise: The trust’s value was not some $10 billion, as the trustees had told the media, but closer to $6 billion.

As part of the reforms, the trust also created the new post of chief investment officer. After making one interim appointment, the board recruited Belsby, a former real estate consultant for Arthur Anderson, to fill the post in 2003.

One of only two nonnative Hawaiians among Kamehameha School’s senior leadership, Belsby has won praise for making tough decisions and achieving strong returns. In a series of controversial moves, he slashed and then rebuilt the investment staff and embarked on a radical diversification of the trust’s portfolio to reduce its dependence on real estate and ramp up exposure to international equities and alternative investments.

Those actions have reduced the trust’s weighting in Hawaiian real estate to 24 percent of the portfolio as of March 31, from 30 percent at the end of 2002, and slashed its mainland real estate holdings to 2 percent from 7 percent. Five years ago the trust didn’t invest in hedge funds; they now make up 11 percent of the portfolio. International equities have grown to 24 percent of assets (of which 7 percent is in emerging markets) from 9 percent, and U.S. equities have been pared to 16 percent from 25 percent. Belsby also has halved the trust’s fixed-income allocation to 11 percent.

“The transition over the past five years has been one of the most remarkable in the oversight of institutional assets,” says Matt Lincoln, a Cambridge Associates consultant who has advised the estate since 1983.

Belsby’s diversification has paid off handsomely. In the fiscal year ended June 30, 2006, the most recent for which complete data is available, the portfolio returned 17.0 percent -- Hawaiian real estate alone was up 29.5 percent -- placing it in the top decile of its peers, according to Cambridge. Over three years it has generated an average annual return of 15.1 percent, compared with a median return of 14.7 percent for its peer group.

But the CIO still faces significant challenges. The trust remains overweight in real estate, and that situation is not likely to change anytime soon. “Hawaiians don’t look at land apart from life,” says attorney J. Douglas Ing, chairman of the board of trustees and a Kamehameha Schools graduate. “It’s very difficult to part with.”

The risk is heightened because more than 95 percent of the land’s value derives from less than 2 percent of the trust’s holdings. (More than 98 percent of the trust’s acreage is agricultural or conservation land and not valued on its books.) And the trust’s 1.1 million square feet of commercial property is exposed to potential hazards, from tsunamis to terrorism to the long-term threat of rising sea levels caused by global warming. “Quite frankly, we probably have more risk than I’d like to assume,” Belsby allows.

Diversification isn’t risk-free, either, as Kamehameha discovered with its Goldman stake. When the investment bank went public in 1999, the trust’s investment was worth $1.5 billion. Kamehameha sold its shares in five tranches over the next three years, reaping some $2.5 billion in total. But because the trust had made the investment through a for-profit subsidiary, it had to pay out some 40 percent in federal and state capital gains taxes. Kamehameha also missed out on the subsequent surge in Goldman’s shares; that 10 percent stake would be worth some $7.5 billion today.

Meanwhile, Belsby’s push into alternatives has been slower than anticipated. The 11 percent hedge fund allocation falls short of the 15 percent target that the trust adopted in October 2006. Belsby is lagging even further in private equity and venture capital, which accounts for just 4 percent of the portfolio, compared with a target of 11 percent. To help improve the pace of investing, the trust in 2005 hired Elizabeth Hokada, who handled stock, bond and hedge fund investments for the University of Michigan’s endowment, to oversee all non-real-estate investments.

Last year the trustees and Mailer told Belsby to proceed with a long-standing plan to form an investment advisory committee whose members could help Kamehameha gain entrée to top-tier venture capital and hedge funds. By late June, Hokada had filled three of five slots, and she has scheduled a first meeting for October. Joining the committee: renowned investment banker Sandy Robertson, who had served in a similar position at his alma mater, the University of Michigan; Constance Lau, a former Kamehameha trustee and president and CEO of Hawaiian Electric Industries, the state’s largest company by sales; and Laurance Hoagland, vice president and CIO of the William and Flora Hewlett Foundation.

“I think Kamehameha Schools is a great cause,” says Hoagland, explaining his decision to join the committee. “Having been in the amount of trouble they were before and turned it around so well, they deserve some encouragement.”

In 1795, when Kamehameha the Great sailed to Oahu to unify the kingdom of Hawaii, his convoy of canoes landed first on the quiet shores of Waikiki. Today this two-mile stretch of crowded beaches and high-rise hotels is the center of Hawaii’s tourist industry and among the most-valuable real estate in the world. It’s also the financial epicenter of the Kamehameha Schools, whose main 600-acre campus sits on a hillside northwest of Waikiki, offering sweeping views of downtown Honolulu and its harbor.

The crown jewel of the Kamehameha empire is the Royal Hawaiian Shopping Center, a six-acre site that stretches three blocks along Kalakaua Avenue, Waikiki’s main drag. The trust also owns the land under the adjacent Royal Hawaiian Hotel and the luxurious Kahala Hotel & Resort, which overlooks nearby Diamond Head. The value of these and other properties surpasses $1 billion. All told, the trust’s holdings, encompassing more than 550 square miles of land spread throughout the islands, are worth some $2.5 billion.

When Belsby arrived in 2003, he found that for all of its hotels, shopping centers, golf courses and other commercial properties, the trust had not been a particularly attentive landlord or developer. Much of its sprawling portfolio was leased on terms that did not give the trust a share of revenues from commercial enterprises on the property. “I found a large collection of assets and some principles established,” Belsby says, “but we hadn’t really developed a full strategic plan for people, business processes, finance and the use of technology.”

The new CIO set out to change that. In 2004 he made one of his toughest decisions: firing 150 property managers from a for-profit subsidiary, Pauahi Management Corp., and handing over the work to a California real estate developer, Festival Companies. Mass firings are rare in Hawaii, a small state, and were inconceivable at the island’s wealthiest and most powerful private institution, one that is dedicated to a native culture that values group harmony.

“It was an incredibly courageous thing to take on,” recalls Cambridge Associates’ Lincoln. “Hawaii does not have a deep job market, so when people lose their jobs, it’s not easy to be hired.”

“It was very difficult, but I had to put our mission first,” acknowledges Belsby. He says employees were offered generous severance packages, and many found jobs with the new developer. In addition to lowering management costs by more than $1 million a year, the switch led to higher rents, occupancy and tenant quality and has boosted top-line revenues by 10 percent annually over the past three years, Belsby says.

The move set the stage for a more aggressive approach to real estate development, notably the $115 million, two-year renovation of the Royal Hawaiian Shopping Center, the trust’s single most valuable property. The complex deteriorated in the 1990s as Japanese tourism slumped; before the renovation it was nearly half vacant. Redeveloped in conjunction with Festival, the three-building mall is set to become a commercial and cultural hub after its grand opening later this year. Its 110 stores will include flagship outlets of Salvatore Ferragamo, Hermès and Apple, as well as ten restaurants, and it will offer daily classes in hula, ukulele and lei-making in a grove of 54 coconut trees. On the top floor Cove Entertainment is building a $15 million theater with retractable chairs and catwalks that at night will turn into a hip club akin to Studio 54 in Las Vegas.

When the renovation began, says Belsby, the shopping center was valued at $150 million to $200 million. Upon completion it should be worth some $600 million and generate more than $30 million in annual revenue.

Kamehameha Schools’ other major real estate developments are less glitzy, in keeping with a land management policy adopted in 2003 that seeks to balance educational, cultural, economic and environmental concerns. On the island of Hawaii, Kamehameha is planning to develop a new resort at Keauhou that will allow visitors to experience traditional Hawaiian culture and hike in the trust’s conservation lands.

Redeveloping the 600-acre Kaka’ako District along the waterfront west of Waikiki has for years been a major goal of the Hawaii Community Development Authority. The Asia Pacific Research Center will be built on land owned by Kamehameha Schools near the John A. Burns School of Medicine, which opened a new, $150 million campus at the University of Hawaii at Manoa in 2005. The goal is to nurture high-tech industries and diversify an economy increasingly dominated by tourism and low-paid jobs.

The CIO also hopes to extract more cash from the trust’s agricultural and conservation lands, which constitute more than 98 percent of its acreage yet yield little revenue. Ideas under consideration include setting up wind farms and growing sugar cane to produce ethanol.

Belsby’s success in boosting revenues from commercial properties only serves to enhance the geographic risk of the trust’s Hawaiian property portfolio, which represents 24 percent of its total assets. That compares with an average real estate allocation of 4.4 percent among large educational endowments, according to the Washington-based National Association of College and University Business Officers.

The valuable assets are highly concentrated, mostly in the Waikiki area. And the risk is almost certain to rise in tandem with local land values: The value of the trust’s Hawaiian property jumped 29.5 percent in the 12 months through June 2006, to $2.03 billion, and is up an annualized 12.7 percent over the past five years.

Spooked by 9/11, the Indian Ocean tsunami and Hurricane Katrina, the trustees commissioned in February 2006 a report on the potential consequences of various disasters. “They are remote risks, but we nevertheless must consider them,” says chairman Ing. Surrounded by the Pacific Ring of Fire, a belt of oceanic trenches, volcanic mountain ranges and clashing tectonic plates, Hawaii is vulnerable to tsunamis. In 1946 a tsunami originating in the Aleutian Islands with waves as high as 55 feet killed more than 170 people, mostly on the island of Hawaii.

Tsunamis are unpredictable, but scientists are increasingly convinced that global warming and a resultant rise in sea levels portend massive destruction of Hawaii’s beaches. Already, one third of the Waikiki shoreline is hardened seawalls, and at high tide much of the beach is narrow or unusable. Chip Fletcher, chairman of the department of geology and geophysics at the University of Hawaii, says rising sea levels could be devastating by the end of the century. “Easily 50 to 70 percent of Waikiki becomes fully inundated and isolated from the main body of the island. It begins to look very much like a barrier island.

To mitigate the risks of the trust’s concentrated commercial property portfolio, Belsby has taken out catastrophic and event-risk insurance. He is optimistic about a strategy to sell future cash streams from property rentals to investors. “That would take the risk of receiving those cash flows off the table without selling the property,” he says. Kamehameha Schools is still studying the legal and tax consequences of these contracts, and Belsby reckons it will be “a migrational strategy.” In the meantime, the trust has allocated 6 percent of its capital to assets that act as a hedge against a downturn in the tourism industry, including energy, timberland, mining, Treasury Inflation-Protected Securities and commodities.

Although native opposition has prevented Belsby from selling Hawaiian property, the executive decided when he came on board that it made no sense to keep the portfolio’s mainland real estate, which included nearly 300,000 acres of timberland in Michigan’s Upper Peninsula and a stake in the Robert Trent Jones Golf Club outside Washington, a haunt of presidents and political power brokers. In 2003 and 2004, Belsby slashed the allocation to mainland real estate to 3 percent and shifted assets into absolute-return strategies. He also began the process of cutting the trust’s fixed-income allocation and boosting its holdings of international stocks.

The sluggish progress made toward gaining exposure to private equity and venture capital has been the trust’s biggest weakness so far. Hokada has taken a patient approach, making small investments here and there to get in the door. One of her biggest advantages is the appeal of the trust’s mission. “Everyone thinks education is important, so it helps to strike a chord,” she says. “I didn’t know anything about it until she laid out its goal and described the plight of the native Hawaiians,” says Jay Hoag, a co-founder of Technology Crossover Investments, a Silicon Valley venture capital firm with $4.7 billion under management. He says the trust invested $5 million to $10 million in a $1.4 billion fund raised in 2005.

Lest anyone forget Kamehameha’s mission, e-mails from Hokada and other trust employees regularly use Hawaiian salutations (such as “aloha e,” or “greetings, addressee,” and “me ka mahalo nui,” or “with much gratitude”). The backs of their business cards have a list of Hawaiian values, including Aloha (Love and respect for the Lord, our natural world, and one another is our foundation) and ‘Ike pono (Urges us to integrate our intellect and our intuition). “It might be a little corny, but it does mean a lot to us,” says Hokada.

Not that all is harmonious among the Hawaiians. A small but influential group of critics charge that Kamehameha could further its mission and boost its endowment by becoming a not-for-profit corporation managed by a board of directors.

“There’s no other educational institution of that size that’s run by a group of five judicially appointed trustees,” says Robert Midkiff, an advocate of conversion who is president of the Atherton Family Foundation, a Honolulu-based charitable trust.

A bigger and broader board of top-tier businesspeople and financiers, Midkiff argues, also could solicit big donations. Contributions have been critical to the growth of university endowments, but Kamehameha’s trustees don’t seek donations. That’s the job of the trust’s affiliate, the Ke Ali’i Pauahi Foundation, but it took in less than $1 million last year.

Chairman Ing and CEO Mailer oppose converting Kamehameha Schools to a not-for-profit, warning that a board of directors would have the power to ignore Princess Bernice’s will, potentially putting Kamehameha Schools’ educational and cultural mission at risk. “Many view the trust as among the last remnants of the kingdom, so to tamper with the will is bound to create controversy,” says Ing.

Absent greater inflows of contributions, however, it will be difficult to reduce the trust’s exposure to Hawaiian real estate and expand Kamehameha Schools’ efforts to fulfill its founder’s mission.