Oct. 8 (Bloomberg) -- Losing money with 86 percent of its fund managers last year is giving Jane Mendillo, chief executive officer of Harvard Management Co., a big excuse to return to the university’s investing roots by making more of its own decisions on what to buy and sell.

The credit unit of buyout firm Bain Capital LLC and TPG- Axon Capital Management LP were among the 54 funds that lost money for Harvard University’s endowment while just nine posted gains, according to internal data obtained by Bloomberg News. About 60 percent of the funds fell short of targets used by the endowment, second in assets only to the $30 billion Bill & Melinda Gates Foundation among U.S. nonprofit institutions.

Mendillo, who joined Harvard in July 2008 from Wellesley College, is reducing the influence of independent firms that oversee two-thirds of the $26 billion endowment after last month reporting a record $10 billion loss for the year ended June 30. The decline left assets at the same level as 2005, when Jack Meyer quit as Harvard Management CEO after 15 years. In that time, he increased the fund’s value almost sixfold, with half of it handled by independent managers, up from 15 percent when he started.

“I very much understand having their portfolio in-house, understanding what their exposures are and if they chose to raise liquidity, the ability to do it,” said William T. Spitz, who ran the endowment of Vanderbilt University in Nashville, Tennessee, for 23 years.

Departure of Meyer

Meyer, 64, took more than 30 people with him to start Convexity Capital Management LP in Boston after alumni complained that pay at Harvard Management was out of control. In 2003, after the top six in-house managers earned a combined $107.5 million in the previous fiscal year, a group from Harvard’s Class of 1969 wrote to Lawrence Summers, then the school’s president, calling the pay excessive and saying more money should be used for scholarships, even if that meant lower returns from the endowment.

Companies not affiliated with Harvard handled about a third of the university’s assets by 1999, a year after two Harvard traders, Jonathon Jacobson and Michael Eisenson, left to start their own firms. Meyer farmed out money to Jacobson’s hedge fund, Highfields Capital Management LP, and Eisenson’s Charlesbank Capital Partners LLC, which manages private equity and real estate. Both Boston-based firms still work for the endowment.

Meyer continued to increase the use of external managers until his departure in 2005, when the firm he started began to invest on behalf of Harvard.

Mohamed El-Erian, 51, who succeeded Meyer in February 2006, said he wouldn’t let the endowment become overly reliant on a single team or strategy again, cutting the fund’s traditional dependence on bonds and shifting more assets to buyout funds and non-U.S. markets.

‘Cost Effective’

Mendillo, 51, took over from El-Erian after he quit and returned to Pacific Investment Management Co., the Newport Beach, California-based firm that manages the world’s biggest bond fund. She had worked at Harvard for 15 years, including as Meyer’s vice president of external management, before leaving in 2002 to become the first chief investment officer at Wellesley, in the Boston suburb of Wellesley, Massachusetts.

She declined to comment on Harvard’s external fund managers or her plans to shift more money in-house.

Managing investments internally is “extraordinarily cost effective,” gives the fund more control of its holdings and makes it easier to meet the funding needs of the university, Mendillo wrote in a report on the endowment’s performance released on Sept. 10.

Management Fees

Independent managers cost about twice as much, and “this significant difference is obfuscated by the reporting practices of the industry,” El-Erian wrote in his 2008 book, “When Markets Collide: Investment Strategies for the Age of Global Economic Change.” The costs of paying external managers are subtracted from their returns, while the pay of internal managers “attract considerable attention in the media,” he wrote.

Harvard’s average annual gain on hedge funds and private equity before subtracting fees was about 14 percent in the decade through June, according to an estimate by Mebane Faber, a fund manager at Cambria Investment Management Inc. in El Segundo, California, and co-author of “The Ivy Portfolio: How to Invest Like the Top Endowments and Avoid Bear Markets.”

$760 Million

If the school had achieved that return in 2008, it would have paid about $760 million in fees, according to an estimate by an investment-industry executive, who asked not to be identified because he advises endowments. The estimate is based on industry average fees of 2 percent on about $15 billion in externally run assets such as hedge funds and private equity, plus 20 percent of the investment profit minus fees, as well as 1 percent on Harvard’s remaining $10 billion of externally managed assets. That’s more than seven times the payouts to Harvard’s top managers that drew criticism from alumni in 2003. The endowment that year was $19 billion.

Harvard doesn’t disclose information about its external managers, said Christine Heenan, a university spokeswoman.

Of the 25 largest funds by assets, Bain’s Sankaty Advisors LLC, TPG-Axon and Cairo-based investment bank EFG-Hermes had the biggest losses relative to benchmarks.

Edward Lampert’s ESL Investments Inc. had the highest relative returns, followed by Lone Star Funds and New Vernon Capital LLC in Jersey City, New Jersey.

Internal Results

The five largest investments run by Harvard’s external managers lost money, including those at Adage Capital Management LP and Baupost Group LLC, though the firms exceeded benchmarks and performed no worse than the endowment’s 27 percent decline.

Six of 11 Harvard Management-run funds listed in the internal results outperformed their benchmarks. A third made money.

The internal data lists investments by category and manager, information that wasn’t provided in the Sept. 10 report. The data cover the period of July 1, 2008, through June 19, 2009, all but one trading week of the fiscal year.

The data don’t include returns by individual private- equity or real estate managers, whose results often take longer to calculate than firms that focus on publicly traded assets.

Largest Ivy Loss

Harvard’s loss was the largest in the Ivy League, which consists of eight of the most prestigious institutions in higher education. It was followed by Cornell University in Ithaca, New York, with a 26 percent decline, and Yale University in New Haven, Connecticut, which lost 25 percent.

Dartmouth College in Hanover, New Hampshire, has yet to release returns for its endowment, which had fallen 21 percent as of December, according to Standard & Poor’s Ratings Services in New York.

Those schools are among dozens across the country that have relied on hard-to-sell assets such as private equity, real estate and hedge funds to produce returns exceeding market indexes. Harvard’s investments rose an average 8.9 percent a year in the decade through June, compared with an average loss of 2.2 percent by the Standard & Poor’s 500 Index and a gain of 3.2 percent by an index of schools tracked by Wilshire Associates Inc., an investment-consulting firm in Santa Monica, California.

Mendillo may also face criticism as she brings more of the endowment’s management back to Harvard employees if compensation mirrors that of Meyer’s era, said Stanley Eleff, a lawyer in Tampa, Florida, who was part of the group of 1969 graduates who wrote to Summers. He said he and his former classmates are drafting a new letter to President Drew Faust.

Alumni Criticism

“The level of compensation was inappropriate at a time when there was no apparent reason to believe that the performance of the endowment was anything other than one of the wonders of the Western world,” Eleff said. “Even if they were able, by bringing more money in-house or otherwise, to return to those halcyon days, we would still be viewing that level of compensation inappropriate.”

Harvard was caught short of cash after the bankruptcy of New York-based Lehman Brothers Holdings Inc. in September 2008 crippled financial markets, forcing the school to fire workers and sell $2.5 billion of bonds. A 30 percent drop in the endowment’s overall value, including distributions to the school, forced spending cuts, layoffs and delays in a planned $1 billion science center.

‘Liquidity Crisis’

“Things can be very good -- you can look at the long-term return over 30 years, but if you have a liquidity crisis, it forces you to post collateral,” said Donald Guloien, chief executive officer of Manulife Financial Corp., North America’s largest insurer by market value. The Toronto-based company managed C$421 billion ($397 billion) as of June 30.

Among Harvard’s biggest external funds, the worst performers relative to benchmarks were spread across investment styles.

Its high-yield debt holdings with a fund run by Sankaty lost 65 percent to $134 million in the year through June 19 and trailed the school’s index by 61 percentage points. The Prospect Harbor Credit Partners fund, which uses leverage to bet that loan values will rise, jumped 77 percent from Jan. 1 through Sept. 30, according to a person familiar with the matter.

Alex Stanton, a spokesman for Boston-based Sankaty, which oversees $19 billion in fixed-income and credit strategies, declined to comment.

Dinakar Singh

The school’s stake with New York-based TPG-Axon, a hedge- fund firm that wagers on both rising and falling stock prices, dropped 30 percent to $158 million, 16 percentage points more than its benchmark, the results show. The firm, led by former Goldman Sachs Group Inc. head in-house trader Dinakar Singh, has gained about 15 percent from Jan. 1 through Sept. 25, according to a person familiar with the matter, as stocks recovered from their March nadir.

TPG-Axon, which manages about $10 billion, was formed in early 2005 by Singh, 40, with three colleagues from Goldman as well as Fort Worth, Texas-based buyout firm TPG. Its 28 percent return since inception compares with a loss of 1.6 percent by the HFR Global Hedge Fund Index.

Paul Caminiti, a spokesman for TPG-Axon, declined to comment on returns.

Harvard’s investment in a Middle East fund run by EFG- Hermes fell 45 percent to $209 million, also lagging behind its benchmark by 16 percentage points, according to the data. The fund was started in September 2007 with Harvard, according to its Web site. Mohamed Abdel-Halim, a director for EFG-Hermes Asset Management, which oversees about $8 billion, declined to comment.

Absolute-Return Funds

Harvard listed $5.1 billion in investments with so-called absolute-return funds, the most after private equity, which had $5.5 billion in assets, according to the internal data. Managers listed in the absolute-return group with results that did worse than their benchmarks include Dwight Anderson’s New York-based Ospraie Management LLC, which shut its biggest fund last year; Old Lane, whose owner Citigroup Inc. took a $202 million writedown after closing the New York-based fund in June 2008; and Thomas Steyer’s Farallon Capital Management LLC in San Francisco.

The school’s stake in ESL, Lampert’s Greenwich, Connecticut-based stock hedge-fund firm, gained 12 percent to $134 million, beating its benchmark by 39 percentage points. Its holdings in the Lone Star VI Fund, which focuses on debt, mortgages and corporate assets, rose 7.5 percent to $229 million, topping the Dallas-based firm’s target by 21 percentage points.

Adage, Baupost

Among its biggest outside managers, U.S. equities overseen by Adage Capital lost 17 percent to $2.16 billion, according to the results. The Boston-based firm, started by former Harvard fund managers Robert Atchinson and Philip Gross, exceeded its index by 9.2 percentage points.

Baupost lost 8 percent, leaving the school’s stake at $1.85 billion. The Boston-based hedge-fund firm, run by Harvard Business School graduate Seth Klarman, outperformed its benchmark by 5.7 percent.

Harvard’s investments with Meyer’s Convexity lost 27 percent to $722 million. That’s 4.5 percentage points better than its benchmark, according to the report.

Officials for the firms either declined to comment or didn’t return calls seeking comment.

“The overall experience at Harvard is similar to other sophisticated endowments,” said Alan Dorsey, head of investment strategy and risk at Neuberger Berman LLC in New York, which manages $158 billion for institutions and wealthy clients. “Even the best endowments in the world can get squeezed in a crisis.”

To contact the reporter on this story: Gillian Wee in New York at gwee3@bloomberg.net;

Last Updated: October 8, 2009 00:01 EDT