Trustee chair quits amid bear market

By Zac Farber

Just two months ago, if you had half a billion dollars and a desire to double it, Jeffrey Larson ’79, chairman of Macalester’s Board of Trustees and a hotshot hedge fund manager, could do it-for a hefty price, that is.But this July due to market anomalies tied to the subprime loans debacle, a heavy reliance on a borrowing practice, known as leveraging, and a lack of diversification, Larson’s Boston hedge fund, Sowood Capital Management L.P., plummeted. After losing more than $1.5 billion of its investors’ money, the fund sold its remaining assets to Citadel Investment Group.

The collapse of the fund made headlines throughout the summer. Karl Egge, Larson’s two-time economics professor who recently transitioned into semi-retirement after teaching economics at Macalester for 37 years, said he told Larson via e-mail “that this isn’t as bad as having a child die, but it’s still bad.”

Larson subsequently gave up his chairmanship of the board of trustees and, with it, his position on the board’s influential investing committee.

Reached at his home on Monday, Larson told The Mac Weekly he resigned because “the demands on my time will not allow me to give the Board the commitment it deserves.”

While Macalester invested no money in Larson’s fund because of a by-law that prohibits the college from engaging in such business dealings with its trustees, other major institutions invested in Sowood and lost tens to hundreds of millions of dollars. Harvard Management Company (which manages Harvard University’s endowment) lost more than $350 million, the Massachusetts state pension fund lost $30 million and the philanthropic Boston Foundation lost almost $20 million.

Amid this summer’s volatile market, Sowood remains the only large hedge fund to have imploded so disastrously. This singularity prompts questions: What led to the collapse of Larson’s seemingly infallible hedge fund? Can Larson’s risky choices be to blame?

News reports and a Macalester professor, who is acquainted with Larson, said that it was probably a combination of the two factors.

A native of River Falls, Wis., Larson started out small. He was attracted to Macalester because of its debate program and excelled as the team garnered national awards. The debating experience may have helped Larson hone his financial acumen, Egge said. “The debaters I’ve had as students always tend to be better students than non-debaters,” he explained. “He could not only hold himself in exams but could understand concepts as well.”

After graduating Larson got a job as an economic analyst at Cargill, Inc., a Minnesota-based company that trades agricultural commodities. He performed well at Cargill, advancing into the financial services sector of the company. In 1991 Harvard Management Company recruited Larson to its ranks.

In more than a decade at Harvard Management, Larson was an integral part of the team that saw the endowment swell from around $5 billion in 1991 to more than $20 billion by the time he left in 2004.

Larson’s success in coaxing returns that exceeded the market average by a large margin earned him a salary of $17.3 million in 2003 and creature comforts such as a $2.5 million dollar house on South Woodside Avenue-the street for which Sowood was named-in Wellesley, Mass. Tax filings show his family foundation was worth over $13 million in December 2005, and it is unlikely to have decreased because Larson invested that money separately from his hedge fund.

But Larson’s pay struck the Harvard community as exorbitant. He departed soon after to start Sowood. Harvard’s endowment became the fund’s first account, investing $500 million.

Hedge funds make money by finding small differences in the price or value of securities (anything that has financial value, including stocks and bonds) and borrowing money to exploit the difference. It’s like “scooping up pennies and nickels with a great big bulldozer,” Egge said.

At Sowood, Larson was effective with these strategies for his first few years, making investors more than 15 percent a year on their money. Harvard’s $500 million initial investment ballooned to more than $700 million before it deflated this July.

The strategy that caused Sowood’s demise is relatively standard in the industry. He bought bonds from companies and short sold (made money when the price went down) their stock.

While the companies from which Sowood bought bonds and stocks were not directly involved in selling subprime mortgages, they were financially entangled with companies that did. In July, the bonds plummeted while the stocks gained value, an economic anomaly and a blow to Larson’s strategy, but in itself not lethal.

What got Larson in trouble was that he did not have enough cash to pay back his creditors. To comply with the law regarding leveraging, he had to sell the same bonds that were rapidly losing value, spiraling Sowood downward into what is known as a classic death cycle. “I imagine that this particular trade was a very big bet for Sowood and their other bets were insufficient,” Egge said.

Sowood’s funds lost more than half of their value before Larson was able to broker a deal with Citadel to salvage his fund’s remaining value.

So what was the ultimate cause of Sowood’s downfall? Leveraging is a prime suspect but with the proper precautions it can be a wise investment strategy.

Diversification is one such precaution that it appears Larson did not take, Egge said. “You like to have a variety of investment strategies.”

The idea of a backup plan was also either missing or unsuccessful for Sowood. “When you are an independent company, where is your sugar daddy?” Egge asked. For example, he said, if Larson suffered a similar problem while working at Harvard Management, the resources of the rest of the endowment could have bailed him out.

Though Larson still has millions of dollars in his personal bank account, his hedge fund’s collapse has probably damaged him more than it has Harvard. Despite the $350 million dollar blip, the endowment’s value increased more than 20 percent in the past year.

Though a review of court dockets revealed no lawsuits yet filed in relation to Sowood’s fall, Egge said litigation is a possibility.

“This is going to drag on for a couple of years,” Egge said.

While Larson told The Mac Weekly he has “no current plans” for his professional future, Egge believes that the talent that propelled Larson through a quarter century of successful money management will not go wasted on Wall Street.

“It wouldn’t surprise me if some hedge fund asked him to manage a large chunk of money again,” Egge said.

Editor in Chief Matthew Stone contributed reporting.