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Harvard Management Company

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Harvard Management Company (2010)

Section A4

Aayush Beriwala, Robert Van’t Hoff, Kristina Ivanova,

Andrea Panzeri, Konstantin Rau

Executive summary

This report presents an analysis of Harvard Management Company’s (HMC) management practices for Harvard University’s endowment fund as of 2010, and aims to provide recommendations to Mrs. Mendillo as CEO of the company. In order to provide specific recommendations, various parts of the firm were analysed. The current split between internal and external asset management was deemed to be suboptimal, since a high amount of the risk and performance was managed outside of the company. Going forward, this split should be moved to around a 50:50 ratio managed externally and internally. A major issue for the company was its liquidity management, with 66% of assets allocated in illiquid assets (6+ months). This issue should be addressed in the short term by lowering this percentage and establishing a target liquidity ratio, and in the long term - by creating a custom benchmark for HMC’s liquidity management. In terms of overall risk exposure, the endowment grew in importance relative to the university’s total budget. This led to the conclusion that hedging and insurances practices should be increased to keep the company operating at low risk levels. Creating comparables for HMC would be difficult looking at other universities. Endowment funds in general tend to have their funds managed externally and have significantly different risk, asset allocation and size profiles than HMC, making them hardly comparable. Regarding asset allocation, this paper proposes a shift away from HMC’s current commodities and fixed income positions towards domestic equities and natural resources. This is due to risk-return performance and general economic sentiment in 2010, expecting opportunities in equity markets and downward pressure on interest rates. Overall, HMC outperforms its competitors on many levels while managing with low risk. Liquidity management was the most noticeable issue Mendillo will have to face in the future in order to maintain success.

Was the current split between internal and external assets optimal? What was the right number of external funds Harvard should invest in, weighting the benefits of diversification against the higher costs and risks of monitoring a higher number of investments?

In our view, the current allocation of assets between internal and external management is not optimal. Although both options present benefits and drawbacks, we believe that the portion of assets allocated to external management should be reduced to 40%-50% of the total assets under management. The main reason that brought us to this conclusion is the fact that through internal management, Harvard Management Company will be able to assess the total risk exposure more efficiently and precisely. In fact, risk reports for external asset managers are less transparent than internal ones and that could make it more difficult to fully track the exposure to illiquid assets, in which generally third parties invest.

Moreover, internal management offers several advantages in terms of costs and fee structure. In fact, as shown in Figure 1, it can be seen that internal management fees are almost 75% percent lower than those for third parties and the performance fee is given only if managers outperform the benchmark and distributed according to a structure that is built they receive only a portion of it with the rest being deferred in case of subsequent losses.

Furthermore, 62 external managers are too many counterparties for Harvard Management company to deal with. We believe that the number of third parties should be brought down to around 40 so that Harvard Management Company is able to request information and monitor more efficiently the risk exposure of each one due to its a stronger position. Moreover, this would help reduce transaction costs therefore reducing the overall cost structure of the fund.

Finally, we would advise Harvard Management Company to shift part of the assets from private investments, such as private equity and real estate, which are managed by external funds, to publicly traded securities which are mainly internally managed. This will enable Harvard Management Company to improve control systems over the risk exposure and reduce costs without having the problem of hiring too many people.

With respect to liquidity, was the endowment now appropriately positioned? Should there be a liquidity benchmark in addition to the policy portfolio benchmark?

Despite the strong performance of investments in illiquid asset classes in the past, the current positioning of the endowment with respect to liquidity should be improved. Due to the increasing cash needs for day-to-day operations and the expansion plans for a second campus, liquidity has become a major concern for the endowment. Moreover, more efficient liquidity management is required because of the large interest-rate swap positions the university has entered in the past – every time the interest rates decrease, HMC is required to post a higher collateral on the swaps. With its current liquidity positioning, however, HMC would not be able to meet the increased liquidity requirements of its operations. According to Figure 2 in Appendix, estimated monthly cash outflows for year 2010 substantially exceed the inflows in every month, resulting in serious liquidity shortages during the whole year. This is attributable to the fact that investments in less liquid assets have increased steadily over time: while the percentage of assets that could be liquidated within 30 days has decreased in the period between 1995 and 2009, the percentage of longer-term assets has experienced considerable growth reaching almost 75% of the entire portfolio in 2009 (Figure 3). In addition, uncalled capital to private investments has risen in the same period, referring to the fact that the endowment should reconsider the amount invested in private funds and focus on more liquid asset classes (Figure 4). As suggested by Mendillo, in order to improve liquidity, HMC should review its exclusively long-term investment strategy and incorporate also short- and medium-term investment horizons in its policy portfolio.

In order to assess to what extent the investment in long-term illiquid assets provides excess returns compared to a more liquid portfolio, HMC could integrate a liquidity benchmark into its portfolio management process. If the difference between the current portfolio and the benchmark is not considerable,



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