SPECIAL REPORT: Harvard’s case of déjà vu

Harvard Management Company kicked off 2017 by announcing a major shakeup with its most profitable group, its real estate team.

The team, which oversees HMC’s $6 billion real estate portfolio and is led by managing director Dan Cummings, is expected to spin out and become an external manager by the end of the year, the endowment’s new chief executive NP ‘Narv’ Narvekar said in a letter in January. The spinout is part of a wave of changes including a shift in the endowment’s investment model and a drastic reduction in its investment staff, that Narvekar announced would be in store for HMC this year.

HMC – the largest US university endowment, with $35.7 billion in assets as of June 30 – distributed $1.7 billion to Harvard University in its fiscal year 2016, amounting to more than one-third of the university’s total operating income.

Real estate, meanwhile, has been the highest-performing asset class for HMC for the past two fiscal years, delivering a 19.4 percent return in 2015 and a 13.8 percent return in 2016. “The real estate portfolio has been a key driver of returns for HMC since the direct platform was established in 2010, and the team will continue to be a valuable partner to HMC moving forward,” Narvekar wrote in his letter.

The team will continue to manage HMC’s direct real estate investments but also will invest capital on behalf of third parties. HMC’s real estate fund investments, meanwhile, would be managed by in-house investment professionals.

This is not the first time that HMC has spun out its real estate team, however. As one industry observer noted: “What’s interesting to me, the further back you go, the more and more you see cycles repeating themselves and history repeating itself.”

Harvard’s first RE spinout

Harvard previously saw its real estate team spin out 20 years earlier, when Harvard Private Capital Group, the endowment’s private equity and real estate investment unit, split from the university to form Charlesbank Capital Partners in 1998. Charlesbank continued to manage a portfolio of $1.4 billion in direct investments on behalf of HMC, leaving approximately $1 billion in fund investments to be managed internally by the endowment.

Michael Eisenson, president and chief executive of Charlesbank, said at the time that the spinout was intended to keep the investment team intact over the long term. “With private investments, you need to keep a long-term focus, and the market was becoming increasingly competitive for attracting top-quality people,” he said in an interview with Pensions and Investments in July 1998. A private company, he added, would have greater flexibility with compensation than an endowment like HMC.

Indeed, the spinout occurred amid public scrutiny and criticism surrounding the compensation of HMC’s investment staff, according to a person familiar with the matter. Moreover, some of the members of HMC’s board did not want to take on certain liabilities, including the recourse liabilities associated with real estate.

The spinout, however, came with unexpected consequences. The overall endowment continued to grow, from $13.3 billion in fiscal 1998 to $17.5 billion in fiscal year 2002, according to Harvard’s financial statements at the time. Meanwhile, HMC’s real estate portfolio – understood to have been approximately 80 percent direct investments and 20 percent fund investments at the time of the spinout – was shrinking as Charlesbank began taking on third-party clients and consequently devoted less time to HMC’s investments.

Finding itself underallocated to the asset class, HMC rehired one of its former real estate investment staff, David Ferrero, back from Charlesbank in 2004 to rebuild its real estate portfolio. As director of real estate investment, Ferrero helped to increase HMC’s “declining” real estate assets from approximately $1 billion to nearly $2.7 billion; expanded its real estate holdings geographically to include Europe, Asia and Latin America; and diversified its portfolio to include real estate investment trusts, direct investments and seed investments in emerging managers, according to his LinkedIn profile.

In accordance with the board’s wishes, HMC’s real estate team remained lean during Ferrero’s tenure. He hired two new real estate staff, Kavindi Wickremage and Ben Brady, and the three were the sole full-time real estate-dedicated investment professionals at the endowment until Ferrero left in 2007. By comparison, HMC is believed to have had 10 or 12 real estate professionals, from analyst to executive level, prior to the spinout of Harvard Private Capital Group.

When the world fell apart

At the end of 2007, HMC’s then president and chief executive, Mohamed El-Erian, departed after less than two years to return to the Pacific Investment Management Company. Not long after, HMC’s board also went through changes, partly because of the onset of the global financial crisis.

“The world fell apart in 2008,” said one industry observer. Like many institutional investors at the time, HMC faced liquidity issues in the aftermath of the crisis; much of its real estate capital, for example, was tied up in closed-end commingled funds. “They decided they didn’t like having positions in real estate funds, because they didn’t have control.”

In response, the endowment opted to shift gears in real estate, hiring Dan Cummings, formerly a managing director at The Carlyle Group and co-CEO and chief investment officer at LaSalle Investment Management, as the new head of the group in June 2009. The following year, it officially launched direct real estate as a major new investment strategy. Concurrently, HMC looked to divest some of its real estate fund interests on the secondary market, including most notably a 2010 offering where it sold hundreds of millions of dollars’ worth of stakes in a number of its real estate funds.

“The repositioning of our real estate portfolio will take several years, but it began in earnest this year with several new investments outside of traditional LP fund structure,” Jane Mendillo, HMC’s then-CEO, wrote in the 2010 endowment report.

Cummings and his team went on to quickly build the direct real estate portfolio. Direct investments accounted for approximately one-third of HMC’s $4.8 billion real estate portfolio in fiscal year 2014, and had risen to be more than 50 percent of its total property holdings just two years later. The team also has grown under Cummings’ aegis, from just a handful of staff in 2009 to almost 25 professionals currently.

“Now the new Harvard CEO says, ‘We don’t want these big teams. We’ll spin out the direct real estate team, we don’t want these liabilities,’” notes one industry observer. “What happened with Charlesbank, it’s being perfectly replicated 20 years later with Dan Cummings’ team.”

Spinout 2.0

The new spinout is believed to be driven by both Harvard and the real estate team itself. Narvekar intends to transition HMC from a specialist investment model – with staff focused on specific asset classes or strategies – to a generalist model where staff would be focused on risk allocation rather than asset allocation. A large team specializing in real estate therefore would be seen as being at odds with the new investment model.

Moreover, Narvekar, who was chief executive of Columbia University Investment Company before joining HMC in December, is seeking to reduce the endowment’s internal operating expenses by cutting its 230-person staff in half by the end of the calendar year. The first round of layoffs, affecting 57 employees, reportedly will begin this month.

The real estate team is understood to be a particularly well-compensated group, with four or five senior-level people that also include senior vice presidents Brady, Wickremage and Orest Hrabowych. Cummings, in fact, is currently one of the highest-paid senior executives at HMC, earning $8.7 million in total compensation for calendar year 2014, according to a 2014 tax return that Harvard University released in May. This made him the third-highest paid executive at HMC that year, following then-president and chief executive Jane Medillo, who earned $13.8 million and then-head of alternative assets Andrew Wiltshire, who earned $10.4 million. He also was one of the highest-paid HMC personnel the previous year, taking home $5.4 million.

“That’s a heavy cost load,” said a person familiar with HMC. “They’re one of the more top-heavy groups, so it makes sense to cut costs by allowing them to spin out.”
And the real estate team is said to have its own reasons for wanting to become an independent firm. “They want to grow and they can’t grow if they invest with just Harvard,” said another industry source.

For the fiscal year ending June 30, HMC’s real estate portfolio generated a 13.8 percent return, beating its 9.2 percent benchmark, with its direct real estate strategy earning a total return of 20.2 percent during the period. By contrast, HMC reported an overall return of -2 percent for the 12-month period.

Yet HMC’s strong real estate performance – which in turn has fueled the growth of the portfolio – has been viewed as a mixed blessing. “The percentage that real estate is of the overall endowment is growing too big for Harvard’s comfort,” the industry source said.

Real estate had a strategic asset allocation of 14.5 percent in fiscal year 2016, the second-largest asset class allocation at HMC after private equity, which had an allocation of 20 percent, according to its fiscal 2016 report. By comparison, real estate’s target asset allocation was 12 percent in fiscal 2015, 10 percent in fiscal 2014 and 9 percent in fiscal 2008.

Retention seeker

Meanwhile, executive compensation at HMC remains a source of controversy. In November, an alumni group called for HMC to overhaul its pay structure, as staff compensation continued to increase in spite of the endowment’s underperformance.

Nonetheless, compensation also is a key component of retaining talent. Echoing Eisenson’s comments from two decades earlier, Narvekar noted HMC’s challenges with employee retention in his January letter: “In the past, HMC’s unique approach of investing in internally-managed portfolios generated superior returns. In recent years, however, the tremendous flow of capital to external managers has created a great deal of competition for both talent and ideas, therefore making it more difficult to attract and retain the necessary investment expertise.”

Scott Perry, a partner at investment consulting firm NEPC, agreed. “This is a real issue for endowments right now,” he said. “We are at eight years and counting for the bull market in equities. As such, some asset management firms, especially those focused on alternative assets, are well positioned to compete for talent versus other market participants. Further, endowment budgets remain stretched and the prospect of lower returns going forward limits the ability of endowments to pursue additional resources.”

In light of these constraints, it is unsurprising that certain investment teams at endowments would want to strike out on their own. “Given the robust fundraising environment for private market strategies, there is certainly some incentive for talented teams with tangible track records to consider a more entrepreneurial approach,” said Perry. “In many cases, compensation is a key driver for teams to set up their own shops.”

Meanwhile, it makes sense for endowments such as Harvard to pursue a generalist model as one way to improve retention, noted Margaret Chen, head of CA Capital Management, the outsourced chief investment officer business at Boston-based investment firm Cambridge Associates.

“A generalist model tends to be an advantage if you want to build your team over time,” she said. “First, it may be harder to recruit specialists and second, it’s much harder to retain specialists. If you’re a specialist in a more narrow or focused area like real estate, for example, that person becomes more desirable in the market. Folks who have significant experience, who know a lot of the fund managers out there, are the specialists that become more sought after.”

The type of investment model that an organization adopts is often predicated on its size and exposure to alternative assets, Chen explained. “If you’re a smaller endowment, you are more likely to have a generalist model. It can be more expensive to have a specialist model, and a specialist model may be unnecessary,” she said. “When you’re a large endowment, you’re often putting a lot of dollars to work in alternatives, so it can make more sense to have a specialist model. Relationships matter in this space to help gain access. It requires getting to know fund managers, and knowing the opportunities in the market. This comes with time and experience.”

Even with its planned staffing reduction, an endowment like HMC will remain a fairly large organization, but that is not necessarily incompatible with the generalist model, she added. “When you’re a generalist, you can be a generalist working across broad asset strategies, like both public equities and hedge funds,” said Chen. “It’s not as focused as someone whose work only involves hedge funds.”

Perry believed that other endowments could follow HMC’s example. “With continued pressure on budgets and an ongoing battle for talent, it’s likely that the generalist model will continue to gain momentum,” he said.

Although there are notable similarities between HMC’s two real estate spinouts, a key difference is the new generalist model under which the latest spinout will occur. The success of the new investment approach could ultimately decide whether cycles will repeat themselves in another 20 years.