Harvard selling $1.5 billion in private equity investments

With the poor performance of stocks since 1999 and with interest rates at historically low levels, private equity investments have become all the rage, especially among university endowments. The bear market of 2008 may have changed that trend as universities found themselves squeezed for cash after the Lehman Brothers bankruptcy. Many learned that their need for liquidity was greater than they had anticipated and that the liquidity premium private equity investments have isn't a free lunch -- it's compensation for risk that tends to appear at the worst of times.

In 2008, Harvard, the world's richest college, saw its endowment lose a record 27 percent. That loss led the university to:

-- Sell $2.5 billion in bonds in December of that year
-- Cut jobs
-- Postpone building projects
-- Pay almost $500 million during the fiscal year ended June 30, 2009 to get out of $1.1 billion of interest-rate swaps intended to hedge variable-rate debt for capital projects
-- Agree to pay $425 million over 30 to 40 years to offset an additional $764 million in swaps

Now, Harvard Management Co., which oversees the school's $32 billion endowment, is cutting its investments in the types of private equity investments that caused the large losses in 2008. It announced plans to offer about $1 billion of stakes in predominantly U.S. buyout funds through UBS AG. And it's already taking bids on about $500 million in energy investments.

One reason that there had been such a large increase in private equity was the success of the Yale endowment, which invested heavily in private equity. However, a closer look might have led to a different conclusion.

A study on the performance of the public equity investments of the highly successful Yale endowment found that the returns were fully explained by exposure to risk factors and not manager skill. The endowment's exposure to small-cap and value stocks provided the excess returns over the Wilshire 5000 (the chosen benchmark). A similar result was found internationally. While the endowment beat its benchmark (MSCI EAFE Index), the outperformance was explained by exposure to emerging market stocks and the same common risk factors. In other words, the benchmarks were wrong.

The authors concluded that any disciplined investor with a high risk tolerance could replicate Yale's results using publicly available index funds and some degree of leverage. They added that they saw value in Yale's broad diversification across asset classes with relatively low correlation.

The implication is striking: If Yale, with all of its resources, can't identify the future alpha generators, what are the odds less well endowed universities can do so? And what are the odds that individual investors can do so?