The Stanford Endowment Experiment

Of the many unflattering stories that are told about the Stanford University endowment, the one about Jason Zhang may be the worst.

It was 2005. Zhang was fresh out of Stanford’s business school and “one of those superstars,” says a former boss. Zhang had been tasked with creating an “emerging Asia” investment program for the Stanford Management Company (SMC), buying a $45 million anchor stake in a small local Chinese private equity group. This was Zhang’s first allocation. It would make the university nearly half a billion dollars. But Zhang would be long gone before that became apparent.

“There was basically a blank sheet of paper, and the senior Stanford people told me, ‘Go figure it out,’” Zhang recalls. He couldn’t look to peers for a model, either. “Most international investors were not doing much in China. If they were, it was giving money to the big names with Asia offices: Carlyle, Warburg Pincus, etc. We took a different approach.”

Over three years, SMC put itself on the map as a frontrunner in emerging-market Asia. It applied for a license to invest in the domestic Chinese equities market, created new teams of local managers, and deployed upwards of $500 million across the region. Zhang and then-CEO Mike McCaffery had envisioned a long-term goal from the very beginning: SMC’s first satellite office, in China, which Zhang would set up after a few years proving his mettle.

Art by Wesley Allsbrook

As he crisscrossed Asia—taking up to a dozen meetings a day in search of deals—a brew of market circumstance and personal opportunity gathered above SMC. Zhang had no way of predicting the event that would kick off a decade of turmoil at SMC: On January 9, 2006, the fund’s leadership quit en masse.

CEO Mike McCaffery, CIO Mike Ross, and private equity chief Dave Burke were leaving Stanford to launch Makena Capital—an outsourced-CIO (OCIO) shop—across from SMC on Sand Hill Road, the artery at the heart of Silicon Valley. The announcement threw SMC into crisis. No McCaffery meant no China office, at least until a new leader approved it. The mass resignation “came as a shock to me,” Zhang says. “To be very honest, it was a disappointment. I was working well with everyone, having a lot of fun, and making great investments. The bottom line was that we were making so much money: It was great for the school. But they saw an opportunity and went for it—everyone has that right.” Zhang stayed on through the six-month search for Stanford’s new leadership. “I was still working pretty hard,” he says, “but wondering the whole time, ‘What’s going to happen?’”

Foremost, hot markets. Elite endowments have a reputation for generous compensation (by institutional standards), but no one was getting rich working at SMC. McCaffery and Co. returned 18% for Stanford in the 2004 fiscal year, 19.5% in 2005, and the same in 2006. Yet as they ballooned the university’s capital base, their opportunity cost of doing so rose alongside it. Staffers responsible for $1 billion-plus strategies say they earned about $100,000 a year. Talent retention was a problem. SMC leaders had proposed accepting some outside capital, managing it for a fee, and passing the revenue onto staff, according to two insiders. But the board rejected the idea; Makena was born. In place of those leaders, a man named John Powers would come to lead the Stanford Management Company.

No one interviewed blames McCaffery, Ross, and Burke for their decision—even those hurt by it. Indeed, many praised the trio for “stellar market timing.” SMC got an equity stake in the new business and a board seat. Makena, like SMC, would not permit staff to speak on-the-record for this article. CEO Burke sent a statement, saying the team is “proud of our association with Stanford Management Company—both historically and as a current partner in investment endeavors—and we admire their consistent investment execution through cycles and transitions.” That first transition, of course, was the exodus of Burke and Co.

“There are a lot of wonderful things people enjoy about working at an endowment or foundation,” says Nolan Bean, a consultant at Fund Evaluation Group. “But for the folks who left to start Makena, they get equity in that business. You’re not getting equity in Stanford. There are economic considerations at hand.”

Despite the competitive labor market, SMC had the option to hire a proven endowment leader. Nancy Donohue, a Harvard Management Company star, was one of three top candidates. “I did interview for the position and I think so highly of the Stanford community,” she confirms. At the time, Donohue was responsible for approximately half of Harvard’s endowment as vice president for external management, working under then-CEO Mohamed El-Erian. “But, the committee decided to go in another direction,” she says. Donohue instead co-founded Summit Rock Advisors, an OCIO firm managing $10 billion in endowment, foundation, and family assets.

During the leadership transition—a phase marked by turnover—one departure remains etched in the minds of ex-team members. Managing Director Mark Taborsky had been with SMC for five years when John Powers took over the CEO seat in June 2006. This was Powers’ first job at an institution, having spent the four years prior as research director at OCIO firm Hall Capital Partners. Upon his arrival, Taborsky was already discussing a position at Harvard’s endowment with El-Erian. A week or two into Powers’ tenure, Taborsky told him he’d taken the Harvard job and would stay on as long as needed for a smooth transition, according to three people who worked there at the time. His co-workers understood: The Harvard job was a prestigious upward move, and Taborsky’s managers had left SMC.

When Powers heard the news, he canceled the managing director’s key card and banned him from the building. Taborsky’s secretary had to pack and ship his remaining personal effects. “There was no, ‘Thanks for your service,’” says one witness to the scene. “I just thought, ‘Wow.’ That was the first data point of Powers’ entire tenure.”

Taborsky went on to senior positions at Harvard, PIMCO, and, since 2011, at BlackRock as a managing director (MD). Staff members shocked by what they perceived to be a hostile handling of this senior-level exit would get used to it. Over the next nine years, SMC underwent bitter splits with two CIOs (Eric Upin and Ken Frier), one CFO (Mark Lee), several senior managers (Dave Hood, Tyler Edelstein, and John O’Connor), the head of portfolio strategy (Mark Hayes), and more.

Like many in the industry, consultant Nolan Bean has noticed the revolving door of employees in and out of SMC. “It’s very disruptive to have that amount of turnover,” he says. “Just as with an asset management firm, when you see all of these people leaving, it raises the question: Is there a reason?”

Jason Zhang stayed seven months under the new administration. The Asian investing program met with less support under Powers than McCaffery. After all, it was the departed CEO’s brainchild, and Zhang his handpicked implementer. The China office plan died (although the notion has resurfaced in recent years).

“I think the most honest answer as to why I left is that the leadership team I was working with left,” Zhang says. “Secondly, I also had a personal reason: I met my future wife and decided to move back to China to be with her. It was not an issue with the people, and besides there were so many interesting opportunities in Asia,” he continues. “At least, not an issue with my old team. I would say I saw a change in the culture of the office under a new leadership.”

Zhang declined to comment further on his experience at post-spinout SMC. However, according to two former staffers, it was not a positive one. Zhang reportedly chose to resign and move back to China when the satellite office project dissolved, offering to stay on for a successful transition. Powers suggested an even better arrangement: If Zhang held on for three months, SMC would give him a substantial bonus and a $100 million anchor investment to launch his own fund in China. Zhang agreed. One person close to the deal called it “a gentlemen’s agreement.” Near the end of the third month, Zhang approached Powers to work out the details, and was asked to stay another three months. He did. June arrived, and once again he went to the CEO to discuss next steps for launching his new fund. Powers told Zhang that SMC would not seed the venture after all, nor would he receive a bonus. Zhang asked why. The reply: “We don’t want to.”
  

Enter 2008. Exit CIO Eric Upin, who had replaced Mike Ross after he left for Makena. Exit two tail-risk hedges—a major credit-default swap and laddered S&P 500 out-of-the-money puts—implemented by Upin and unwound pre-crisis. Exit one-quarter of Stanford’s endowment assets. Enter a years-long distraction from SMC’s festering internal dysfunction. As one person described the situation, “it was a toxic culture, a culture of tyranny, a culture of Washington-Beltway manipulation.”

But larger problems existed. Devastating endowment losses pushed Stanford President John Hennessy to cut endowment payouts, lay off staff, and issue bonds to stave off a liquidity crisis. The California school suffered on par with Yale and Harvard in the 2009 fiscal year—they lost 26%, 25%, and 27%, respectively. Endowments on average lost 19%, with those above $1 billion shedding 21%.

In October 2009, SMC put $6.2 billion of buyout fund, natural resource, and distressed asset stakes on the auction block, seeking to offload up to $1 billion worth. It was either “the biggest fire sale in private equity, ever” (Dow Jones’ LBO Wire) or a strategic play to free up cash and “take advantage of attractive near-term investment opportunities” (Stanford). “We are not forced sellers,” Powers said at the time. And that’s lucky for SMC, since the portfolio received only underwhelming bids. Stanford pulled the sale.

Ironically, Stanford did deliver as an opportunistic buyer: SMC outperformed most of its peers by 300 to 400 basis points in 2010, recovering 14% to Yale’s 9%. Both Powers (in a 2014 speech) and his former deputy Mark Hayes credit the university leadership and SMC’s board with giving them the leash to play tactically. “One of the greatest things about the administration was that its willingness to take risk didn’t change throughout the financial crisis,” says Hayes, who joined in March 2008. “We did have clarity from university leadership that it wanted to win, and they weren’t second-guessing our risk bets.”

Powers, reached by email, described this post-crisis recovery as the personal highlight of his Stanford track record. “When I arrived at SMC in 2006, I found that I needed to re-staff an investment team, since it had seen a number of departures in the prior period,” he wrote. “While this reshaping and rebuilding was in process we entered the financial downturn of 2008 and 2009. Personally I am most proud of the strong results delivered by this new team in the recovery period immediately post the stress of the global financial crisis.”

Continued from here.
  

But Stanford still wanted a reckoning of what went wrong in 2009. Furthermore, turnover at SMC remained high, and office morale low, according to many employees from that time. What does a wealthy organization with a bothersome operational issue do? Call in the consultants.

Over many months, SMC’s investment staff gave interviews, took anonymous surveys, and conducted business as usual amid experts from PDI Ninth House (now Korn Ferry). Their 2011 report identified the problems staff members had been griping about for years, according to ex-employees. (Stanford declined to provide a copy.) Many people, both inside and outside of SMC, expected this scathing account would usher the end of Powers. It didn’t.

“They came back with a D or F on basically every metric for SMC: infighting, politics, are people happy to come to work, etc.,” says a mid-level former employee. “The consultants formally identified a clear division between an inside circle and an outside circle. These two groups experienced palpably different levels of access, power, transparency, closed-door meetings, and information on general goings-on.” The insiders—said to include Saguna Malhotra (private equity MD), Wafa Wei (absolute return and fixed income MD), and Vera Kotlik (Wei’s junior partner)—“were all sort of anointed.”

This velvet-rope dynamic came up in every interview conducted below the MD level for this story. Those who joined SMC’s mid or lower tiers speak movingly about the damage suffered by employees too junior for the firing line. Mark
“The most frequent comment was, ‘Man, this could be so much better.’ Given the reputation, standing, and brand of the institution, it could be the dream job.”Hayes, for example, took on the role of portfolio strategy head “to tackle the big gaps in SMC strategy and try to move us to the next level.” Hayes had started closer to the bottom than the top at SMC. He knew what it was like.

“What’s the worst feeling?” asks one alum of the outer circle. “It is coming in with passion, excitement, and high hopes, and having this years-long frittering away of the dream you signed on for. The most frequent comment—and I would hear this often—was, ‘Man, this could be so much better.’ Given the reputation, standing, and brand of the institution, it could be the dream job. To me, that is the real tragedy: The potential not fully realized. This is where I think leadership and culture can kill firms. If you let people down, or disenfranchise them, that’s when they lose their morale.” Asked if he felt like most people wanted to come to work in the morning, he paused. “Most of them, no.”

Powers says improving SMC’s culture was a priority for him at that time. “I am proud of the efforts we made post-crisis to evolve the team and our internal processes,” he wrote in an email. “Outside of leading the investment team, my focus was on strengthening SMC by growing a positive and productive corporate culture and by creating a transparent and shared decision process. Work on these goals continued across the organization up until my decision to undertake an entrepreneurial next chapter for myself.”

The consulting report also turned a spotlight on SMC’s culture. “The board saw it, but they instituted leadership and mentoring programs, that kind of thing,” says a former staffer. “They tried to lightly fix it—that didn’t lead to real personnel results.”
   

Around the time of the consultants’ work, the board pushed to fill Eric Upin’s long-vacated CIO role, and split the executive functions. SMC hired Hewlett-Packard’s CIO Ken Frier to take over portfolio management from Powers. It didn’t work. He signed on for a task he never had the chance to do, according to several senior colleagues. Winning means one thing at SMC, and the president and board were never shy about spelling it out: Beat Yale.

Judging by Frier’s prior work, he was up to the challenge. It was, however, a cultural shift. “There’s a lot of peer-to-peer competitiveness in the endowment world,” he said in a 2013 interview. (Frier declined to comment for this story.) “Stanford is a wonderful institution that tries to compete at every level that a university can compete: In terms of the caliber of the students, the caliber of the faculty, the physical plant, on the sports field. My sense when I interviewed for the job was that the leadership of Stanford wanted to compete in endowment returns as well,” he said.

“When you’re the CIO of Hewlett-Packard and sharing results with your board—and we had always done very well—no one ever asks, ‘How did the IBM retirement plan do?’” he added. “In the big endowment context, when you tell your board how the fund had done, they want to know how the other leading endowments did in the same time period.” Pressure to beat the Ivies went beyond board meetings. It dictated staff paychecks: One-third of SMC’s senior investment team’s bonuses were (and likely still are) tied to performance relative to peers on a rolling three-year basis.

“The lack of a CIO speaks to the dearth of quality and rigor that was involved in our investing process.”“I think you need to be really careful with that from a governance perspective,” says Nolan Bean, the endowment consultant. “There are reasons why you should be different from your peers. Some endowments support the majority of the institution’s operating budget, and they should be conservative. You run the risk of incentivizing the wrong behavior, including excessive risk taking. It also leads to a herding mentality, where everyone wants to copy off their neighbors. Portfolios end up looking mostly like one another, but a little bit different to get that bogey.”

SMC is not getting that bogey, and it isn’t beating Yale. In the nine years under Powers’ leadership, Stanford bested David Swensen’s team twice: In 2010, with 14.4% versus Yale’s 8.9%, and 2011, edging out Yale by 50 basis points. Over the 10 years ending June 30, 2015, Yale leads Stanford 10% to 8.7%. 

Compared to the broader universe of endowments, Stanford is consistently top-half. Powers and his team returned an annualized 13.1% over five years ending in 2014, whereas $1 billion-plus endowments earned an average 12.1%. On Stanford’s $22 billion, and compounded over several years, those 100 basis points of alpha represent a lot of scholarships. But for Stanford’s president and SMC’s board, the explicit goal was always to be number one—not better than average. A dedicated chief investment officer could have helped, according to former staff members and an endowment consultant.

“There were a couple of critical, turbulent market years where we went without a CIO,” says an SMC alum. “The nature of an endowment is such that a CEO role can be highly ambassadorial—but then there is also the day-to-day investment mission. The lack of a CIO speaks to the dearth of quality and rigor that was involved in our investing process.” A number of elite endowments go without separate CEO and CIO roles, including Yale and Notre Dame. But both have leaders (under the CIO title) who prioritize investing tasks over the ambassadorial, and have led their teams for decades.

As a best practice for large funds, NEPC’s head endowment and foundation consultant Cathy Konicki advises splitting the role. “It’s a lot of responsibilities for one person,” she says. “There is so much to administrate with investment staff and decisions versus the ongoing running of an organization. I’m sure it can and has been done well, but I think that with an organization of that size, you probably need to have both a CIO and CEO.”

At the very least, for optics. Stanford desperately needed a “grown-up” with serious investing chops in a leadership role, ex-staffers say. “Our reputation degraded over time and we came to be seen as the ‘B-Team’ of investors, or as lightweights,” says one. “I heard that from a number of general partners, former allocations, fellow allocators… If a leader brings in people who are sort of green for senior positions, they will know their career and seniority are because of that leader. You end up with ‘yes men.’ That reflects in the quality of the work.”

Mark Hayes was one of those “sort of green” investors. He joined in 2008 two rungs below an MD, climbed to head of natural resources, and then to a deputy CIO position, where he spent three years. But a ‘yes man’ he is not. “What did I really enjoy about my team? We’d sit down and have arguments, sometimes vehemently,” he says. “These are really smart people, and I’m not going to be the one to come in with the answer.” But outside of Hayes’ own team, he admits that dynamic wouldn’t play well. “With John [Powers], you were always a little bit measured in your words,” he reflects. “He didn’t really have a stomach for dissent. And I do think tolerance for that has to come from the top.”

Intolerance for dissent flows the same way: downhill. Hayes—like so many others before him—eventually caught the SMC senior-staff curse. Still, he recognizes that he was both the beneficiary and victim of Stanford’s culture. Frequent churn and a preference for early-career investors opened the incredible opportunity of managing a world-class endowment at a young age. Hayes effectively became Stanford’s deputy CIO at 35-years-old, given access to the highest echelon of investing. “If you ask anyone in the professional asset management business, opportunities don’t get better than that: $25 billion in capital, one client, and a lot of autonomy and support from university leadership to secure the ship,” he says.

On the flip side, that opportunity comes with an expiration date. Hayes’ was October 27, 2014. “I can’t say I was surprised,” he recalls. “It’s no secret that we did not have a great collaborative culture throughout my whole tenure. We were too siloed in the early years, and the attempts to build more collaboration didn’t really work. That was disappointing to me.”

Ask almost anyone in the tight-knit cadre of SMC vets about Powers firing Hayes, and you’ll hear it was “the last straw” for the CEO himself. As with the Makena spinout, leadership change meant various forces and circumstances clicking into alignment—and Hayes’ exit was the final piece. As Hemingway describes going broke, it happened slowly at first, and then all at once. Precisely 15 days after Powers told Hayes he was “done” with him, Stanford issued a press release: “Stanford Management Company CEO John Powers to Depart in 2015.”

Powers explained in the release that he had “decided it was time to take my enthusiasm for business-building and find a new challenge.” University President Hennessy said he would begin the search immediately for a new CEO, and praised Powers’ work in building SMC’s investment team.
  

Few staff members would survive to serve through the next administration. To finally beat Yale, the board bought Yale. In early 2015, Stanford named Rob Wallace—CIO to Alta Advisers, the Tetra Pak family fortune—to succeed Powers as endowment CEO. Wallace had spent several years at David Swensen’s talent incubator, making him not only a smart, but also the safe, bet for SMC’s beleaguered board.

“When you find that level of rot, shine a light on it, and don’t completely remove it, it’s not fixable.”“Rob had one of the best track records out there when he managed Alta Advisers, but it was a secret so nobody knew how good the numbers were,” says Randy Kim, CIO of the Conrad N. Hilton Foundation and Wallace’s former colleague. “He was one of the most talented people I had the pleasure of working with at Yale, and I’m very confident he will turn things around at Stanford, especially by adding high quality people like Greg [Milani] and Jay [Kang].” Wallace hired Kang, Kim’s former deputy, as one of SMC’s first new managing directors.

Bruce Dunlevie, venture capital titan and chair of SMC’s board, had similar praise for the former professional ballet dancer. “The board of SMC is thrilled to have been able to attract Rob Wallace, SMC’s recently appointed CEO, to continue investing the university’s endowment with an elite group of investment managers around the world.”

The industry reacted to Wallace’s cull with shock. Yet those tied to SMC—alums, general partners, and close peers—say they admire his bravery in creating carte blanche for SMC 2.0. “I don’t know this new guy,” says a relatively unscathed vet of the last administration. “But I think he’s very passionate about investing. There is still going to be pain as he’s cleaning up, but I don’t think there was any other option. When you find that level of rot, shine a light on it, and don’t completely remove it, it’s not fixable. I’m sure the board gave him freedom to completely remove the tumor—to do whatever it takes.”
  

If a leader fires or forces out nearly every person who rises to senior ranks, fails to meet his crystal-clear mandate (irrelevant as it may be)—yet holds one of the most sought-after positions in institutional investing—how does that leader keep his job for nine years?

Powers’ former employees have a view. Jason Zhang—who did end up opening that China office, but for Morgan Creek—puts it succinctly. “Obviously, governance has room to improve.”