Harvard Endowment Increases Modestly to $37.1 Billion During Early Stages of Overhaul
Performance highlights for fiscal 2017:
•The endowment’s value stood at $37.1 billion as of June 30, the end of fiscal year 2017, an increase of $1.4 billion (3.9 percent) from $35.7 billion a year earlier. (The endowment had reached $37.6 billion at the end of fiscal 2015—finally exceeding the nominal peak value, not adjusted for inflation, reported in fiscal 2008, immediately before the financial crisis and recession.) The reported rate of return and growth in endowment value likely trailed peer institutions’ results, in part reflecting troubled natural-resources investments.
•In a year of improved investment returns generally, Harvard Management Company (HMC) recorded an 8.1 percent return on endowment assets during fiscal 2017, reversing the negative 2.0 percent return reported in the prior year. The return figures take investment fees and expenses into account. (Among other institutions with diversified portfolios reporting to date, Dartmouth realized a 14.6 percent return on its $5-billion endowment; the perennially strong MIT 14.3 percent on its $14.8-billion endowment; and the University of Virginia 12.4 percent on its $8.6-billion asset pool. Princeton, Stanford, and Yale—Harvard’s nearest peers in asset size and diversification into illiquid assets such as private equity, venture capital, real estate, and natural resources—have yet to report.)
•HMC discontinued reporting results by asset class or segment, consistent with its new investment-management strategies and disciplines, and did not publish its performance benchmarks. In his letter, CEO N.P. Narvekar noted, “Performance reflects strong returns from public equity, private equity, and our direct real-estate platform, while natural resources experienced a challenging year.” Overall, he wrote, “Our performance is disappointing and not where it needs to be.”
•In a classic instance of “past performance is no guarantee of future results,” the figures reported today principally reflect investment decisions made before Narvekar’s appointment, announced in September 2016 and effective last December 5. This past January, he unveiled sweeping changes in HMC’s organization and investment approach, including significant reductions in personnel and the hiring of new senior managers. Although many of the short-term changes were effected before the end of the fiscal year, on June 30, Narvekar telegraphed in his January communication that “transforming HMC’s organization and portfolio is a five-year process.” (A significant constraint is the time it takes for many long-term, illiquid investments to mature and for the assets to be reinvested in accord with Narvekar’s new disciplines, by the newly arrived managers entrusted with making endowment investment decisions.) Thus, although this year’s results will be scrutinized closely, they may provide little if any insight into the ultimate effects of the major changes under way at HMC.
•HMC did not break out, nor has the University disclosed, one-time restructuring costs—such as severance payments or losses (if any) on the sale of investments—that may have affected the reported investment return, and therefore the value of the endowment, this year. Given the size of the endowment and its annual returns, any such costs, if incurred, may not be considered material for accounting purposes, and therefore may not have to be reported. The one area Narvekar highlighted (again without quantifying the impact) was natural resources, where for years HMC’s internally managed program “generated strong returns” (investing in timberland and related assets, for instance). “At this stage,” he wrote, “while most assets remain attractive, a few have significant challenges” and the board of directors “took some markdowns on value prior to my arrival, and we have taken more markdowns in fiscal year 2017, which meaningfully impacted our results.”
•The increase in endowment value reflects three intersecting factors:
- the positive investment return;
- the regular distribution of funds—a withdrawal from the endowment’s value, to support Harvard’s operations—and possibly other one-time distributions, so-called “decapitalizations”; and
- the gifts added to the endowment, as pledges are fulfilled and the proceeds received—the fruits of The Harvard Campaign, which has reported more than $8 billion of gifts and pledges to date.
The points highlighted here are discussed in further detail below, along with a report on HMC’s fiscal 2017 results in the larger context of the organization’s overhaul. The changes initiated by Narvekar are driven by the need to improve persistently lagging performance relative to the University’s long-term financial goals and objectives: through the five- and 10-year periods ending June 30, 2016, HMC’s compound annualized rate of return was 5.9 percent and 5.7 percent, respectively, versus the University’s planning assumption of 8.0 percent returns: a huge difference when applied to an endowment corpus of $37 billion, and compounded over time. Updated returns through fiscal 2017 were not published in Narvekar’s letter.
Results in Fiscal 2017
The Harvard Management Company (HMC), which invests the University’s endowment and other financial assets, today disclosed that the endowment’s value increased 3.9 percent, to $37.1 billion, as of the end of the fiscal year, this past June 30. The compares to a 5.1 percent decrease in the endowment’s value during fiscal 2016, and a 3.3 percent gain during fiscal 2015.
In absolute terms, the endowment’s value increased $1.4 billion during the year just ended, reflecting the intersection of:
Appreciation. HMC’s in-house and external money managers realized an aggregate 8.1 percent investment gain (realized and unrealized; after all expenses) during fiscal 2017, producing an increase in value of perhaps $2.5 billion to $3 billion. (This estimate excludes transfers and timing differences that go into the final rate-of-return calculation and reported endowment value; actual figures are reported in Harvard’s annual financial report, released in mid autumn.) These are the rates of return in recent years and the associated changes in the value of the endowment (after distributions to support the University operating budget, discussed immediately below, and gifts received). The data illustrate the magnitude of changes in the value of the endowment, given both its large corpus and the effects of the operating distribution (which appear most vividly in years when investment returns are minimal or negative):
- Fiscal 2016: (2.0) percent (year-end value $35.7 billion)
- Fiscal 2015: 5.8 percent (year-end value $37.6 billion)
- Fiscal 2014: 15.4 percent (year-end value $36.4 billion)
- Fiscal 2013: 11.3 percent (year-end value $32.7 billion)
- Fiscal 2012: (0.05) percent (year-end value $30.7 billion)
- Fiscal 2011: 21.4 percent (year-end value $32 billion)
- Fiscal 2010: 11.0 percent (year-end value $27.4 billion)
The reported rate of return encompasses some restructuring costs. Narvekar forecast in January that HMC’s 230-person staff would be reduced by half by the end of this calendar year, through layoffs and spinning out certain asset-management functions. That transition is associated with the change from a “hybrid” model, with a large internal staff investing a significant share of the assets while external firms invested the rest, toward a dramatically smaller internal staff overseeing outside managers. Accordingly, HMC undoubtedly absorbed severance costs during fiscal 2017. Reductions of that size may also mean relinquishing space and reconfiguring offices in HMC’s headquarters at the Federal Reserve Bank tower in downtown Boston. Both would involve reorganization costs.
Absent any separate disclosure, it is unclear whether any of those organizational restructuring costs (or gains) had a meaningful effect on the value of the endowment at the end of fiscal 2017. If the sums were material, that would interest deans and their faculties, given the formula (explained here) by which the Harvard Corporation determines future distributions.
The results also reflect moves to restructure the investment portfolio. Narvekar sold some of the endowment’s private-equity and real-estate assets on the secondary market at the end of the fiscal year, providing liquid resources he and colleagues can invest in new strategies or opportunities. It is not known whether those sales resulted in gains or losses, or whether the proceeds realized had any effect on the valuation accorded other assets HMC retained. Obviously, the natural-resources changes loomed large.
Distributions. The endowment exists to support the University’s operation; accordingly, its value is reduced (in years of negative investment returns, further reduced) by distributions to support Harvard’s operating budget, and other distributions for one-time purposes (“decapitalizations”). The operating distributions totaled perhaps $1.8 billion in fiscal 2017—up about 4 percent from the $1.71 billion distributed in fiscal 2016 (and $1.59 billion in fiscal 2015).
Decapitalizations vary widely from year to year; the fiscal 2016 sum was $128 million, down from $193 million the prior year. (Again, comparable figures for fiscal 2017 become available when the University’s annual financial report is published later this autumn.)
The operating distributions are of paramount importance: they are the largest source of revenue for the University budget, accounting for 36 percent of operating revenue in fiscal 2016, and much higher shares for certain units (51 percent of Faculty of Arts and Sciences income in that year, for example).
Given the decline in the endowment’s value during fiscal 2016, deans have already been told to expect no increase in their operating distribution during the current fiscal year, 2018, and are sharpening pencils to determine what their budgets might be for the following one, beginning next July 1.
Hence the interest in determining whether the fiscal 2017 results reflect one-time losses (or gains) of any meaningful size (and if so, how the Corporation weights them in determining the 2019 distribution).
Gifts. Finally, the endowment’s value is augmented by capital gifts received during the year and payments on pledges of gifts for the endowment made earlier. The University is very much the beneficiary of supporters’ largess, especially during The Harvard Campaign.
Of course, not all gifts are for endowment—many donors contribute funds for current use, or to underwrite building projects; and pledges may be fulfilled long after they are announced. Harvard’s fiscal 2016 financial report indicated pledges receivable, of all sorts, totaling $2.1 billion, of which $1.1 billion was designated for endowment; among gift receipts recognized in the financial statements for that year were $492 million in endowment proceeds and $421 million in current-use giving. (The comparable figures for fiscal 2015 were $338 million in endowment gifts and $436 million in current-use funds.) Once again, the exact figure will be released with Harvard’s fiscal 2017 financial report this autumn.
Thus, the rough arithmetic would be:
$35.7 billion beginning value as of July 1, 2016
plus $2.5 billion to $3 billion (fiscal 2017 investment gains),
minus $1.8 billion (operating distributions for the University budget, with no estimate for decapitalizations),
plus perhaps $0.5 billion in gifts for endowment received and new pledges,
equal the endowment’s $37.1-billion value as of this past June 30.
The Market Environment
Investors had a much easier time of it in fiscal 2017 than during the prior year, when market returns as a whole were break-even to barely positive. During fiscal 2017, the Wilshire Trust Universe Comparison Service reported that the median returns for large endowments were in the range of 12 percent to nearly 14 percent—a huge improvement compared to the median return of negative 1 percent in the prior year.
Public equities (stocks); high-yield bonds; and private-equity investments appeared to perform well for endowments that have reported results and disclosed returns by asset class. Real estate and hedge funds (absolute-return investments) also appear to have produced positive returns, if not at the rates reported in other classes. The Princeton, Stanford, and Yale reports may provide further useful detail, but the scattered data from other diversified, if smaller, higher-education endowments are consistent with Narvekar’s summary comment highlighted above. Consistent with his focus on long-term performance, his letter did not contain any observations on current market conditions or the outlook for fiscal 2018.
HMC under (Re)Construction
Reporting on HMC last year (see the “Theories of Change” section here), this magazine said the organization’s board of directors could:
- stay the course as laid out by Stephen Blyth, who had stepped down as president and CEO for medical reasons, after putting in place a complex new asset-allocation model within the hybrid management structure; or
- pursue “changes of a different kind,” perhaps reflecting the judgment that circumstances had eclipsed “the internal portfolio managers, and the organization’s competitive challenge in securing and retaining the best talent for its investing staff,” and its asset-class-based “policy portfolio” model.
As Narvekar’s appointment and subsequent decisions have made clear, HMC has opted for the latter course, involving sweeping changes in personnel, investment strategies, and processes. Clearing away any doubts, Narvekar’s letter today amplified the work he outlined in January and actions taken to date. He wrote:
Indeed, the opportunity to improve this is what attracted me to the leadership role of Harvard Management Company. The endowment’s returns are a symptom of deep structural problems at HMC and the resultant significant issues in the portfolio. These matters have challenged HMC for years, despite a highly talented and dedicated team of professionals and active support from the University and the HMC board of directors.
Outsiders may be surprised by the scope of the operating changes he reported:
- The relative value platform has shut down. We expect that two of these teams will continue to be external partners to Harvard on a going-forward basis.
- The internally managed equity platform has shut down.
- The credit platform has been repositioned and is currently executing its strategy internally. We expect this team to depart HMC and are working to execute a mutually beneficial arrangement as an external manager.
- The real estate platform responsible for direct investments is also expected to spin out. We are working closely with the team to support this effort and to execute a mutually beneficial arrangement as an external manager.
- The size of the support organization has been reduced as a result of our new investment approach.
Nor is that all; he indicated changes in strategy and culture that he intends to bring about over time:
HMC’s investment professionals have historically focused their work within specific asset classes. Over time, however, this “silo” approach created unintended consequences. Portfolio managers conducted research and analysis and executed investment decisions within their respective asset class independent of the rest of the portfolio, sometimes creating both gaps in the portfolio and unnecessary duplication. This model also created an overemphasis on individual asset class benchmarks. Overall, I believe the silo approach did not lead to the best investment thinking for a major endowment.
We have now moved our approach towards a generalist investment model in which all members of the investment team take ownership of the entire portfolio. The team will have a singular focus: the performance of the overall endowment. We will engage in focused debate and discussion about investment opportunities, both within asset classes and across the investment universe.…
A successful investment organization is reliant upon the development and execution of an appropriate organizational culture.
Besides the obvious need to strive for excellence and to conduct ourselves with integrity, we seek to build an organization that is highly collaborative and less hierarchical than previously structured. Ultimately, we seek to develop a partnership culture in which colleagues can easily access one another and engage in informal debate. By cultivating ideas from a broad range of team members, we increase the opportunity to make superior investment decisions. This approach will also help maintain high team morale while attracting and retaining top endowment talent.
The letter ultimately details his vision for a “generalist” process with a broadly skilled, stable staff and a new compensation model, based on the performance of the entire endowment, to incentivize their work. Narvekar also reviews how long it may take to realize that vision and the accompanying gains in performance it is intended to achieve.
One shorthand way to judge the scope of those changes is to compare Blyth’s program (linked above, and described in the fiscal 2016 report) to the leaned-down statement of “philosophy” now posted on HMC’s website:
HMC’s generalist investment model breaks down silos among asset classes to search the world for the most attractive risk-adjusted returns. A central tenant of our investment culture is a belief that a disciplined set of processes, practiced by a capable and experienced team, will generate superior long-term results. The generalist investment team includes both Chief Executive Officer Narv Narvekar and Chief Investment Officer [a new position for HMC] Rick Slocum as active participants.
We are keenly focused on building processes—and supporting analytics—and executing them consistently. We combine these processes with a partnership culture in which the collective team engages in focused debates about investment opportunities both within asset classes and across the investment universe. The result is an investment team with a singular focus: the performance of the overall endowment.
The generalist investment team devotes considerable time, thought, and effort to managing the risks inherent in our complex portfolio. Our risk allocation framework expresses the portfolio in betas and alphas, as opposed to asset class allocation, which allows us to estimate the total risk in the portfolio. This understanding of the portion of risk, rather than the portion of dollars, coming from any one category of investments strengthens our dialogue in determining the appropriate level of risk for Harvard.
Stripped of the investing jargon, that points to a small team of senior professionals—perhaps a couple dozen in all—discussing opportunities and risks across the universe of investment options and making commitments for the endowment as a whole. The decisionmaking process would resemble the HMC of yore not at all. Instead, the operating structure resembles the organization developed at Yale and mirrored at MIT, Princeton, Stanford, and elsewhere (in many cases by professionals who trained in New Haven under David F. Swensen, who has overseen investments there since 1985). Narvekar had the same kind of investing organization at Columbia.
There, however, he developed a distinctive “risk-allocation framework,” hinted at above, which he is deploying at Harvard. Rather than focusing on categories of assets (equities, hedge funds, real estate), it is based on market volatility and risk (“beta”) and the potential excess return of specific investments relative to the market (“alpha”), within an overall view of the institution’s return needs and risk tolerance. The endowment as a whole will be constructed to reflect a desired mix of risk, not by dollars allocated to specific asset classes (as in the policy-portfolio approach HMC formerly employed).
A Long-Term Transition
Effecting these changes involves bringing new personnel to HMC, several of whom are now in place, as Narvekar announced in January. They in turn will have to establish new relationships with external money managers (a pressing priority identified by Blyth as well—after the many changes in HMC’s leadership during the past decade, and its investing constraints in the wake of the large endowment losses in 2008 and 2009). HMC will probably need to build new systems to track its investments and the portfolio overall, consistent with its new disciplines. The board of directors and Harvard’s leadership will have to define the University’s risk tolerance (which naturally differs from those of peers like Penn, Stanford, and Yale, which own and operate large hospital systems, for example, as Harvard does not; and from Princeton’s, given its minuscule professional-school component, compared to Harvard’s). Operationally, HMC will have to determine whether it wants to aim for a certain number of investments of a certain size (making substantial investment commitments to the “conviction” managers it thinks promise the best performance, each of which would have a substantial impact on the aggregate endowment performance); or is willing to pursue a greater number of investments, which would complicate the downsized organization’s task of knowing each one thoroughly.
At some point, Narvekar, the board, and the University will have to determine whether it is realistic, in the current investment environment, to continue to plan for long-term annualized returns of 8 percent. Most peer institutions maintain return assumptions in that range, but a number of large pension funds have begun to reduce their long-term outlooks. Harvard’s financial model presumes that with 8 percent investment returns, the real value of the endowment can be sustained if the operating distribution—the money that runs the place—is about 5 percent of the market value each year, and higher-education cost inflation runs at about 3 percent annually. The stakes are significant: reducing the return assumption by one percentage point, to 7 percent, could imply a 20-percentage-point reduction in the funds distributed to the faculties (from 5 percent of the endowment market value to 4 percent): a shock if imposed suddenly, or a longer-term concern if phased into the distribution over time.
All those issues of execution and planning loom over the transition at HMC. In the meantime, the transition will inherently take time. Illiquid assets are customarily tied up for multiyear periods (the time it takes for a private-equity investment in a company to be made and sold, or to develop and lease a real-estate development). Beyond the sales of private-equity and real-estate assets effected last June, to provide liquid funds for new investments, there is a limit to the volume of new commitments Narvekar and his team can and would confidently make in the near term. From external managers’ perspective, too, it can take years to put newly raised funds to work.
So that five-year period Narvekar cited reflects both the flow of funds from existing HMC investments into new ones over time, and their actual deployment by external managers, which will continue and extend beyond the transition period he sketched.
In a take-your-breath-away paragraph in his letter today, Narvekar wrote that since “the time had come for an aggressive plan to restructure HMC and create the necessary organizational and investment culture,”
[M]y first seven months included establishing a generalist investment model, recruiting new senior investment team members, integrating existing team members from the previous silo model and new team members (including myself ) into our generalist model, spinning off various internal platforms and preparing to spin off others, rebuilding our investment processes and analytics, creating a new risk framework, generating meaningful liquidity, and designing our new compensation framework.
He also acknowledged the difficulty of, in effect, retooling an old-model race car while steering it around the track: “In a perfect world, we would have moved through these changes over a much longer period. However, given the time needed for these changes to impact results, the HMC board of directors and I strongly believe that HMC will be in a far better position by moving quickly. We have done so.”
He concluded with a note of optimism, observing that “my time at Harvard has given me many reasons to be even more optimistic for our future. We are equipped with dynamic investment and support teams and collectively we are driven by our mission to support the educational and research goals of Harvard University. There is certainly much work to be done. However, I am confident that our efforts will ultimately result in a stronger model and improved investment performance that will benefit many future generations of Harvard students, faculty, and staff to come.”
In a supportive statement, Paul J. Finnegan, Harvard’s treasurer and chair of HMC’s board, said, “Narv and his team are making excellent progress in reorganizing HMC to ultimately improve investment performance. The HMC board of directors is fully supportive of these efforts and the time required to reposition HMC so that it can perform up to our collective expectations. We are confident Narv has the right strategy that will deliver in the years ahead.”
The remaking of HMC will be a work in progress for the foreseeable future, even as its personnel, investing disciplines, and actual investments change. Given the size of the endowment, the leverage represented by enhancing its investment returns over time—and the fundamental importance of those returns to the University’s hopes for its teaching and research mission—Narvekar and his colleagues continue to have the most important financial job at Harvard.
Read Narvekar’s letter here.
Follow John Rosenberg @JohnSRosenberg.