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Running the Endowment at an Arm's Length

By Gregory B. Kasowski

From his comfortable 15th floor office in the Federal Reserve Building, Walter M. Cabot '55 looks down onto a prime view of Boston's financial district.

Looking westward from his desk to Financial Plaza, the president of Harvard Management Company (HMC) can see the skyline rising sharply over the Charles River. But his view of Cambridge and the College he once attended has long been obstructed by the sprouting city core.

Cabot says this is the way he had hoped HMC would be when he was chosen to be its founder 17 years ago.

"At an arm's length" was the key phrase when the plans were set down for the first independent firm owned by a university with the sole task of managing its endowment. And as he prepares to step down as president of the company he created in 1974, Cabot says it "is running as well now as it ever has."

But while there seems to be general approval of Cabot's term in office among members of the Harvard community, outside observers have tried to peg the recent announcement of Cabot's resignation to Harvard's hopes for redirecting HMC.

Financial pundits at The Boston Globe and The Wall Street Journal have suggested that HMC's search for a new head is a result of Harvard's displeasure with its long-time endowment manager.

The Globe intimated in a January article that Cabot may have been forced out because of poor relative performance in 1989 and the possible loss of $45 million when a company in which Harvard had invested declared bankruptcy in September.

The Journal questioned the terms under which Cabot was leaving HMC, and rapped his knuckles for not having groomed a successor from the inside.

But Cabot, 57, who suffered a severe heart attack last spring, says he decided to leave after coming to the conclusion then that "17 years is long enough for anybody to run one organization."

"The Globe wanted to show short-term performance was the problem, but that's a joke because in January we built it all back up, and besides, you don't judge somebody on six months versus 17 years," Cabot says. "If I hadn't had a heart attack, I don't think they'd be out searching."

HMC partner Verne Sedlacek agrees with Cabot, saying that during the January downturn on Wall Street "being underinvested in the stock market has helped us. The Globe article was a complete misinterpretation."

And Robert H. Scott, Harvard's vice-president for finance, says reports circulating since the announcement that Cabot was going to step down have been "misinformed."

"We're only looking for a change in the sense that we need to find a replacement for Walter Cabot," Scott says. "Walter played a big part in the company and in developing our investment strategies. I think we've been very fortunate to have had someone as successful as Walter."

Under Cabot's reign, the endowment of the University has grown from $1.3 billion to what is currently just under $5 billion.

An Independent Investor

Financial experts attribute HMC's success in keeping the University's endowment the largest in the nation to two major points--the company's relative independence from Harvard and Cabot's adventurous investment style.

According to Cabot, the success of HMC stems from the independence that the University, "in its wisdom," gave the firm right from its conception. As an example, Cabot points to the fact that the company has its own board of directors, benefit plans for employees, hiring procedures and compensation programs.

And the University was willing to go to a lot of trouble, Cabot says, to put together a "first class organization"--and to give the director himself essentially a free hand in making investment decisions.

"They were willing to pay compensation competitive to the investment world," Cabot says. "And they placed great responsibility on the CEO in the sense that he would manage the activities of the company, that they weren't going to get in the way of investment policy."

Cabot says that although the University does "provide careful oversight," the independent nature of HMC is what he believes makes the difference between the Harvard investment company and the systems at other schools.

"The problem that my colleagues at other universities have is that investment committees dictate what they should do," Cabot says. "My counterparts don't really have a major role."

Roberta M. Weil, vice-president for investments at Columbia University, says Harvard's system for making investment decisions is quite different from the structures at most universities.

"It's certain that the Harvard system offers [Cabot] a lot more freedom, there's no doubting that," Weil says. "Whenever Walter Cabot makes a decision to increase or decrease allocation of endowment in equity, he doesn't have to worry about getting the go-ahead from the board, and I do. So he has certain advantages."

Weil points to Princeton as the only other Ivy League school with an investment firm similar to HMC, but she acknowledges that the two are hardly comparable, given the smaller size and narrower focus of Princeton's investments.

One of the reasons that Harvard has been able to establish an independent but internally-owned company to manage its endowment is that the University is in an unusually strong financial position. While most schools couldn't feasibly support the staff of an investment firm with their limited funds, Cabot says Harvard has the "money and resources it takes" to run an internal management firm.

"Nobody manages the scope of investments Harvard does," Cabot says, adding that many schools look to HMC as an exemplary investment firm, but that few could actually implement a similar system.

A Sometimes Brash Investor

And in the relatively conservative field of endowment management, where each university's goal is primarily to maintain its economic standing, Harvard is seen as a large and sometimes brash investor. The University was among the first to become involved in the realm of venture capital and leveraged buyouts (LBO), both of which offer high yields on investment, but at a high risk.

It is Cabot's willingness to venture into uncharted investment areas that has defined the philosophy of HMC over the course of his tenure. Starting with a portfolio with "100 percent of Harvard's equity in large, common blue-chip stocks," Cabot says he threw out tradition and began looking to areas previously shunned by endowment managers.

"My philosophy is that this is not a portfolio that you should take to the racetrack," Cabot says. "But within that umbrella of protection of capital, if we're going to keep Harvard as the preeminent organization, then we must produce superior returns and you can't do this unless you take risks."

In part, Weil suggests that Harvard's decision to invest in the "less traditional areas" has been not so much a question of a riskier strategy as a function of the University's financial strength. Weil points out that many colleges do not have the money to make the high-return investments Harvard has made.

While it is clear that Harvard's top-ranked endowment gave HMC investment freedom which other schools did not have, it is Cabot's decision to move away from traditional financial deals which helped to more than triple the endowment.

"My traditional philosophy has been the 'tension' portfolio," Cabot says. "The usual standard of performance has been the Standard and Poors 500 index, and it is representative of the large common stocks. I have tried to diversify away from blue-chip into less competitive areas of the equity market."

According to Cabot, one of the major goals of the HMC diversification was to move into areas where Harvard is an "exceptional" investor and can "make a difference" for an individual company.

One of the previously ignored areas which Cabot identified as an opportunity when he first arrived at Harvard was private investing. Over the years, HMC has increased its holdings in private assets in areas as varied as real estate, petroleum and LBOs. The University now has more than $1 billion--about a third of all assets, Cabot says--invested in this type of holding.

Cabot says the HMC portfolio's dependence on large public stocks has now been reduced to just a third of the company's total assets. The final third is made up of high-risk trading and hedging strategies, another area pioneered by Cabot.

"Certain schools have gotten more involved in [higher-risk areas], but it depends on the attitude," Weil says, adding that many institutions abandoned this foray after taking heavy losses in the October 1987 stock market crash.

Shrugging off those who say Harvard should not be involved in the high-risk financial frontier, Cabot says his critics "lack a knowledge of what we're trying to do."

"People don't understand the nature of risk--just because it's different, they think it's risky," Cabot says. "We probably have three or four hundred private investments. Now sure, any one of those could probably go bottoms-up, but the likelihood of all of them [doing so] is very low. So you've diversified the risk."

But the recent bankruptcy of Lomas Financial Corporation in which Harvard had invested $45 million--roughly one percent of the University's endowment--has raised questions about whether the risks are truly worth the potential gain. Harvard has charged the investment firm Merrill Lynch with "misrepresenting" Lomas' viability as an investment and is suing for triple damages over the incident.

HMC's involvement with outside LBOs and venture capital firms has also come into question, particularly after one of the partnerships--Wall Street-based Kohlberg, Kravis, Roberts and Company--took over tobacco and consumer goods producer RJR-Nabisco at a time when the University was questioning its public investments in the company.

But HMC has answered this concern by moving to internally managed LBOs--again a combination of an expert investment team and the University's financial strength makes this an option for Harvard, where it isn't for most schools.

And because many of the investment decisions made in the past few years--like internal management of LBOs--indicate a long-term plan for HMC, Harvard insiders say they doubt the structure and philosophy of HMC will change significantly once Cabot's replacement is found and takes over the reins.

College Treasurer D. Ronald Daniel says that as long as the University does not suddenly change its long-term objectives, then HMC will continue to manage the endowment in the same way as before.

"There is no question of changing the risk-reward strategies," Daniel says. "We're more interested in looking at other areas. We have to strengthen international investment, for example."

Cabot agrees that "if we aren't global in thought then we're not going to be competitive" and says HMC should concentrate its attention on foreign investment over the next decade, but he adds that this should not require a new strategy, just a broader playing field.

"In the next 10 years, we could see as much change here as in the last 10 or 15," Cabot says. "There will be as many opportunities, you just have to be smart enough and have the courage to take them."

In the search for a new president, Daniel says, the priority is not to find someone who wants to turn HMC's investment policies around, but to move the current strategies into a wider arena.

"We need somebody who is both a gifted investment strategist and someone who is a good people person--if you can't get along with the people you have to work with in this business then you won't be successful," Daniel says. "And just as Walter has been, his successor will have to be a leader and an institution builder. We need to replicate the qualities that Walter has shown over the years."

And while Cabot says he is ready to step aside, he hopes the new president isn't going to turn back the clock and "bring [HMC] back into a very traditional, conservative structure that the rest of the world is built on. We're better than that."

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