Before current management terminated the old compensation structure, the huge salary packages at HMC stumped us.  Every time we compiled our CIO compensation studies, we wondered how those paychecks could be so large when performance was so mediocre.

Some fault poor communication, siloed investment teams, and misaligned incentives, but we hear there were other issues – questionable benchmarks and bonuses paid “off-the-mark.”

Here’s how it worked. 

Most of HMC’s assets such as listed equities, fixed income and hedge funds, relied on public market prices.  And the private equity and venture capital portfolios were invested with outside managers who were responsible for valuing the assets.

But the natural resources portfolio was owned directly by HMC and valuations relied on third party appraisers hired by the staff who, in turn, controlled the process.

There were performance benchmarks, of course.  But staff set the benchmarks and beating those benchmarks depended upon valuations and valuations depended on a process controlled by the staff.  In other words, the carry was paid off of unrealized marks on illiquid holdings and superior performance was all but guaranteed.

Even better, there was no easy way to argue against those benchmarks and valuations.  As Matthew Klein wrote in the Financial Times about “private equity’s mark-to-make-believe problem,”

If it’s challenging to figure out what a thing is “worth” when some of the smartest people on the planet, armed with the fastest computers and the biggest datasets, are constantly discussing and betting on its value, it’s downright impossible for investment managers focused on illiquid assets to assess the value of anything they own until they exit their positions by selling to someone else.

Not surprisingly, there was great enthusiasm for these investments within the endowment.

As one source put it to me recently, in Las Vegas, the house wins, but at HMC, the players made the rules.

Fun with FASB

Non-profits must show their investments at “fair value” per FASB 124 on their audited financial statements.  That’s straightforward for publicly-traded securities.  But things get cloudier for illiquid alternative assets with no quoted prices: so-called “level 3” items.  And, it gets cloudiest of all for assets not in the hands of independent third-party managers.

Absent quoted prices the reporting entity must have some reasonable process for establishing those values and for adjusting them up or down from period to period.  If they pass that sniff test, and management has signed off on the process, then the external auditors will probably not second-guess them.

We don’t doubt that HMC had a rational-looking basis for the numbers they printed; but when the process can be influenced by insiders, and those insiders could be said to have a monetary interest in the reported values, there is room for skepticism.  We think the bare fact that there have recently been very significant write-downs under the new management and changes in the way compensation is paid should speak for itself.

Rukaiyah Adams, chief investment officer at Portland’s Meyer Memorial Trust – doing good and investing well

The $90 billion dollar Oregon Pension ranks among the top fifteen in the US, but how many in the industry know the current board chair, Ms. Rukaiyah Adams?

Ms. Adams was born in Berkeley, CA, grew up in diverse, northeast Portland, and returned to her home city after a stellar legal and investment career in California and New York.

She splits her professional duties between the $750 million AUM Meyer Memorial Trust, where she is chief investment officer and the $90 billion Orego​n Investm​​ent Council, where she is board chairperson.

Present day Portland is a little easier to reach than it was when President Thomas Jefferson sent Captain Lewis, Second Lieutenant Clark, and the ‘Corps of Discovery” west to explore the vast uncharted American territories.

Still, Portland is not Wall Street and, at the west end of the Oregon Trail, just far enough off the beaten track to feel a bit isolated. 

Yet, the state is home to the Oregon Investment Council, one of the nation’s largest pension funds, several well-run university endowments, three first-rate investment consulting firms, and the Meyer Memorial Trust, established with a bequest from Mr. Fred G. Meyer, a twentieth century supermarket magnate.

When Mr. Meyer died in 1978 at the age of 92, he left two million shares of stock to the newly formed foundation.  And thanks to a buy-out deal in the early days of private equity, the value of the trust’s holdings soared.  KKR and the Oregon Investment Council, in one of their first joint buyout forays, purchased the Fred Meyer Co. in 1981, which did wonders for the stock.

Ms. Rukaiyah Adams joined the foundation as investment head about four years ago, after managing a $7bn fixed income and derivatives fund for The Standard, a Portland-based financial services company.

We caught up with Ms. Adams earlier this year and wondered what the investment view looked like from her outpost on the Pacific rim.

Ironically, with only a handful of African-American chief investment officers in the entire US, the progressive northwest has two, Ms. Adams, a Portland native, and Joseph Boateng, from Ghana originally, and the long-serving investment head of Casey Family Programs in Seattle, the largest non-government provider of foster care in the country. 

We wanted to know what drew her to the asset management industry, her views on investing, and what advice she might have to offer to encourage more women and minorities to get into the business.

The U.S. has the greatest university system in the world.  But it’s expensive.  And congress is about to make matters worse by taxing the endowment earnings of “large” private college and university endowments.

The latest congressional proposal aims to slap a 1.4 percent excise tax on the net investment income of any private university with an endowment of more than $250,000 per full-time student, about 70 universities.

Unfortunately, universities can ill-afford any additional hits to the bottom line.  A recent report by The College Board, found that a “moderate” college budget for an in-state public college for the 2016–2017 academic year averaged $24,610 and a moderate budget at a private college averaged $49,320.”

Private universities in particular lean heavily on their endowments for tuition assistance and operational support.  Melissa Korn noted in the Wall Street Journal earlier this year, that “schools with endowments over $1 billion funded just over one-third of institutional grant aid from their endowments, while those with endowments of less than $25 million used that pool to cover 5.8% of aid”.

Endowment pools are like savings accounts and endowment earnings the interest.  The more we draw from savings to spend today, the less money we earn to spend tomorrow.

Two years ago, I defended Yale’s endowment, arguing that its capital “is a perpetual source of support for present and future generations of students and faculty and, it takes a long time to accumulate.”

“Cambridge, the wealthiest university in Europe, took 800 years to amass an endowment of $8.1 billion.  Harvard’s $36.4 billion took 377 years to accrue.  Upstart Stanford University grew its endowment to $21.4 billion in “just” 130 years.  And that “hoarded” wealth drove performance; American universities dominate the rankings of global higher education.”

Unfathomably, the latest congressional proposal to tax the earnings of “large” private school endowments turns that reality on its head.  The legislative war cry now seems to be “grab what you can today and let future generations fend for themselves”.

There are four sources of income for American universities and colleges and all four are under pressure.  State and federal support has been dropping for years.  Endowment investment returns appear likely to decrease.  Tuition costs have reached unsustainable levels.  And donor gifts have flatlined.

And that may not be the worst of it.  Clayton M. Christensen, the Kim B. Clark Professor of Business Administration at Harvard Business School (ironically, it’s an endowed chair!), sees half of America’s 4000 colleges and universities going bankrupt in the next decade or two, as online education “disrupts” the business models of traditional institutions and runs them out of business.

Our system of higher education – including the great private universities – has been a key asset in our national preeminence.  Financing that system is a growing challenge, but taxing endowment earnings or forcing unwise spending mandates on a handful of successful institutions will only aggravate the situation.

I closed my Yale piece by saying:

Endowments help channel private wealth to public purposes.  They are an American success story, and one reason Americans have never had to rely solely on the whims of a benevolent state, as in Europe.  I hope Congress doesn’t spoil the ending.

OCIO assets up over 21% in Skorina’s latest OCIO list!

Last month in our annual OCIO report, we listed OCIO assets up 18% from the prior year.  We promised to come back with some additional thoughts about the outsourcing decision for endowments, and here we are.

Now, with recent AUM updates as of June 30th from a few big OCIO providers, we’re reporting $1.7 Trillion in full-discretion assets under management by outsourced chief investment officer firms.

That’s a year-over-year jump of $364 billion – or a little over twenty one percent – since September 2016!

See our OCIO list from last week with these latest updates here: https://www.charlesskorina.com/?p=5145

Our headline now says that total outsourced AUM is up over 21 percent (about $364 billion) year-over-year by our reckoning — but we didn’t hazard any guess about where all that money was coming from.

Our friend Dr. Alan Biller in Menlo Park, whose firm manages almost $40 billion on a full-discretion basis, has some thoughts on the matter.

We profiled Mr. Biller last year. See: Alan Biller: An accidental money manager

https://www.charlesskorina.com/?p=3916

Skorina:

Alan, you deal with prospective OCIO clients on a daily basis.  What do you think is driving the growth in this niche?

Biller:

The effort by corporate pensions to de-risk and off-load their retirement liabilities probably accounts for the lion’s share of the AUM growth, Charles. 

U.S. private pensions totaled about $25 trillion in assets as of year-end 2016 according to the latest OECD report (Organization for Economic Co-operation and Development).  

See http://www.oecd.org/pensions/private-pensions/Pension-Markets-in-Focus-2017.pdf

And endowments, foundations, health systems, charities, etc., account for maybe a tenth of that: $2 to $2.5 trillion.  So, that big jump you see in your list is bifurcated.  The growth rate for pension assets is probably well over 21 percent. The growth rate in E&F is, I suspect, more modest than that.

Pension investors can’t go to their employees for more money to meet unanticipated expenses, and they have no flexibility over distribution.  There are no rewards or promotions for meeting pension obligations; just the prospect of embarrassment if they can’t.  It’s understandable why they’re looking for ways to outsource the headaches!

Skorina: 

OK, we get that the E&F sector is relatively small in the total institutional world and probably hasn’t contributed more than $10 or $20 billion to that year-over-year OCIO growth.  But they’re still very desirable clients to OCIO vendors.  And we know you talk to a lot of them.  What are they saying about their needs?

Biller:

First, they’re worried about returns.  The last year has been great, but don’t forget that trailing 10-year returns have still been pretty poor for most institutions, with many falling short of their long-run targets.  Public market volatility has been high and, having been badly burned in 2009, they’re still worried about risk.

Meanwhile, university cost pressures are increasing, foundations struggle to maintain their level of grant-making, and health-delivery systems are being crushed under regulatory and pricing loads. 

All this is making it very tough for volunteer board members and trustees.  And you could add the rising emphasis on ESG and PRI investing (Environmental/Social/Governance and Principals of Responsive Investing).

There is a widening gap between the hours available from boards and committees on one hand, and the increasing complexity of their responsibilities.  I call it the “fiduciary gap.”  You referred to it as “meeting fatigue” in your last newsletter.  It’s the same thing.  There’s just so much you can reasonably ask of volunteer trustees who often have demanding day jobs.

Skorina:

There’s no doubt that ESG investing is more than a fad.  Just last month, Barnard College in New York switched their OCIO mandate from Investure to Strategic Investment Group because they needed more flexibility and expertise in that area to execute their divestment program.  That’s a $356 million pickup for SIG.

https://www.bloomberg.com/news/articles/2017-09-13/barnard-replaces-investure-as-manager-of-286-million-endowment

Biller:

When I ask a visitor why they are thinking about OCIO, I’m seldom asked about my asset-allocation views, or which managers I use.   Their concerns are more fundamental than that. T hey want to know: How can I keep my money safe?

Pension plans worry about paying their retirees while staying solvent.  Endowments and foundations worry that they may have to cut programs if the markets turn sour.

The people I talk to have a lot of promises to keep in a very uncertain world.  They’re looking for someone they can trust.  All of the technical issues come much later in the conversation.

————————————————– 

Endowment costs: A correction for Harvard

Endowment costs: The secret history

In early 2016 certain Congressional committees sent letters to 65 major private universities asking for information about their endowments.  They supposedly had an urgent need for this data and gave the schools just 30 days to respond.

It was worded as a polite request, but it came from people who could, for instance, compel the endowments to adopt a strict spending rate (like private foundations) instead of the more flexible regime they currently enjoy as “charities.”  Needless to say, the schools all coughed up the information forthwith.

Apparently, this data-dump just went into filing cabinets, and neither the schools nor Congress have been eager to share those reports with the general public.  Nevertheless, we scrounged up copies of 15 of the responding letters from various sources.  The other 50 schools have kept theirs out of sight.

We were especially curious to see what the schools had to say about endowment management costs, which has always been a cloudy issue for us.

Commonfund agrees.  In a 2015 study they opined that:

…unlike other factors that affect investment returns, such as asset allocation and the many types of operational and investment risk, costs are almost certainly the least well understood.

See: Commonfund Institute: Understanding the cost of Investment Management (October 2005).

As we said in our OCIO report, the perceived cost of managing the endowment is a major factor in the decision to outsource, or not to.

It’s not the only factor, but a big one.  But how can a board make that decision if they don’t know whether they’re spending more or less than their peers?  And, whether outsourcing will actually save them any money?

Investment returns can be benchmarked to the second decimal place, but the costs of managing those investments are harder to come by.

NACUBO and Commonfund include questions about those costs in their annual NCSE survey, and report broad averages.  But there is almost no data on specific schools.  We also have suspected that the reported NCSE average costs are on the low side, but had no hard evidence one way or the other.

Recent 990 filings also require a dollar amount for “investment management fees,” but we haven’t had much confidence in that number.

So, we’ve attempted to do our own analysis of the cost data reported by those 15 schools.  It has some limitations, but we seem to be the only ones to have ransacked these letters.

The Nine “normal” endowments

Nine of the endowments offered plausible numbers (expressed as annual dollar amounts and/or percentages of AUM) for both their investment-office costs and fees paid to external money-managers for the three fiscal years 2013-2015.

Here’s what we extracted from their responses.