03.28.09

The Man Who Gutted the Ivy League

When Yale’s endowment fund was soaring, other Ivies rushed to copy the “alternative investment strategy” of chief investment officer David Swensen. Now those funds are a shadow of their former size—and it may be months before we know the full extent of the damage.

The “alternative investment strategy,” which this year has led many university endowment funds to the brink of ruination, was pioneered by David Swensen, Yale’s chief investment officer since 1985. A PhD in economics and lecturer in finance, Swensen achieved such consistently high returns for Yale’s endowment fund until 2009 that the strategy he outlined in his 2000 book Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment, was widely imitated by other university endowment funds. Indeed, at the height of the market, it was difficult to find a major university that was not dancing to Swensen’s tune and, for all practical purposes, it not only replaced the traditional strategy of dividing a portfolio mainly between blue-chip bonds and equities, but also served as the new paradigm for university investment officers.

Despite a year of massive writedowns at private-equity houses, Yale will not know how it has done on two-thirds of its portfolio until June 30, 2009.

The heart of his strategy was to reduce drastically the allocation for bonds, equities, and cash, and substitute for them a portfolio of illiquid investments that included participation in leveraged buyouts, hedge funds, and stockpiles of physical assets. Swensen argued in his book that such illiquid investments carry less risk and more potential for high returns than stocks or bonds. His case was that because endowment funds did not have to concern themselves with withdrawals for taxes or redemptions to their investors, they did not need the liquidity of the major stock and bond markets and could therefore avoid losses from short-term fluctuations.

Swensen’s most persuasive point was his own remarkable performance at Yale. By 2000, he had put most of its endowment fund in illiquid investments. While high-flying U.S. stocks collapsed in the Internet bubble in 2000-01, Yale’s endowment fund made money as its assets rose in value, and it outperformed almost every other major endowment fund—many of which lost money—as its president, Richard Levin, pointed out. Following Swensen’s path, all of the Ivy League schools, including Harvard, with the world’s largest endowment, moved their portfolios into alternative investments.

By 2008, not only had the universities invested most of their money in alternative investments, but, as the price of entry into private-equity and real-estate funds, they made unfunded commitments to add capital equal to slightly more than 25 percent of their entire fund, if called upon to do so by the fund managers.

How illiquid were these alternative investments? Consider, for example, the private-equity funds in which they became limited partners in order to participate in leveraged buyouts and other such deals. The general partners, which were private-equity houses such as KKR, typically required that endowment funds make a multiyear commitment of as long as ten years to not withdraw their investment. They often also required a commitment to furnish additional funds in the response to their “capital call.” If all went well, this additional money would come from the profits that the endowment funds earned in the deals, but if all went badly, they would be liable for raising the money.

Harvard, with about $4 billion in private-equity deals in 2008, is a case in point. Because it had an unfunded commitment of approximately $1 billion for capital calls, it attempted to reduce its exposure by selling some of its private-equity participations to so-called secondary funds. But even when the university offered to sell them at as much as a 35 percent discount, it found no buyers.

Hedge funds, another main channel for alternative investment, provide somewhat better liquidity, but they also can restrict withdrawals by “gating” their fund. Harvard, for example, invested half a billion dollars in a hedge fund called Sowood Capital. But in July 2007 the hedge fund got caught in a complex series of arbitrage trades involving credit-default swaps that wiped out more than half of its capital and, when it couldn’t meet lenders’ demands for more collateral, it turned over its remaining asserts, including what was left of Harvard’s money, to another hedge fund, Citadel Investment Group, which then suspended redemptions.

The other alternative-investment channel in the Swensen strategy is physical assets, including huge tracts of land and real estate. Turning such assets into money can, however, be difficult. Consider what happened to Calpers, the giant pension fund of the California Public Employees’ Retirement System, when it sunk part of its portfolio investment in undeveloped residential and timber land in Arizona, Florida, and California. As home prices fell in 2007-08, Calpers was unable to sell properties for anywhere near the price it paid and, as it borrowed to finance these purchases, it wound up with a 103 percent loss.

Illiquidity was not a problem when notional prices went up in the boom years. When the bubble burst in 2008, however, those prices proved to be largely a mirage. Endowment funds' losses of more than $50 billion call into question Swensen’s strategy of diversifying into illiquid assets. As it turns out, the three main pillars of the diversification—private-equity participations, hedge funds, and physical assets—depend on the same variable: credit. When credit became less available in the financial meltdown, these alternative investments rapidly shed their notional value.

What of Swensen himself? Yale announced a 13.4 percent loss to its $22.5 endowment fund in October 2008 in its “marketable securities.” But that $3 billion loss did not include its illiquid investments, including those outsourced to private-equity funds, which constituted more than two-thirds of its portfolio. Yale President Levin said it is difficult to know exactly how much the university has lost in investments that “are not traded on a daily basis and are difficult to value with precision.”

Swensen shrugged off that problem in February 2009 by saying: “We only mark the portfolio to market once a year, on June 30,” and adding that even this annual reckoning is done merely for financial disclosure and future planning purposes. If so, such willful blindness means that despite a year of massive writedowns at private-equity houses, Yale will not know how it has done on two-thirds of its portfolio until June 30, 2009. Even if Swensen’s once-a-year claim is mere hyperbole intended to show his calm in the eye of a financial storm, it reflects the disconnect between the notional and realizable value of illiquid assets.

The real issue underlying the Swensen strategy is what the purpose of an endowment fund is. If it is to gamble on creating a jackpot large enough for a university to finance large-scale future expansion, his strategy may make sense, as it promises long-term profits. But if its purpose is to assure an institution’s continuity in bad as well as good times, the strategy may be inappropriate, especially if in times of crises, when other money raising is diminished, a university may have to borrow enormous sums to meet capital calls from private-equity houses. Unfortunately, such considerations of purpose tend to be drowned out by the alluring, sweet-sounding tune of a pied piper.

Edward Jay Epstein studied government at Cornell and Harvard, and received a PhD from Harvard in 1973. The Big Picture: The New Logic of Money and Power in Hollywood is his 13th book. The sequel, The Hollywood Economist will be published in January 2010.