Transcript Endowment Management

Hedge Funds, Private Equity, and Leveraged Buyouts
– Unlocking the Mystery of Wall Street: Financial
Literacy for Non-Profits
Gregory J. Muth MPA, MS
Let’s Talk About…
 Alternative Assets for investment:
 Hedge Funds
 Private Equity
 Buy-out Funds, including leveraged-buyouts
 Investment Strategies – old and new
 60 / 40 Rule
 Modern Portfolio Theory
 Value at Risk – Extreme Value Theory
 Investment Returns
 The Yale Model
 The Breakdown – What Happened?
 If You Have Assets to Invest,You Should Have an Investment Policy
Investment Strategies – old and new
 60 / 40 Investment Rule
 Long / Short Non-directional Equity
 Modern Portfolio Theory
 Value at Risk – Extreme Value Theory
Investment Returns
 What is Total Return?
 Why do we Benchmark?
 What you should know:
 All rates of return should be based on “market values”
 Calculating a “rate of return” is simply a matter of applying the
right arithmetic;
 Deterring whether a fund’s rate of return is good or not is
harder.
 Need to use benchmarks, analysis and judgment
The Yale Model
 Relying heavily on modern portfolio theory, Swensen and Yale
endowment managers developed the following five principles, which
have become the basis of the Yale Model:
 Invest in equities, because it is better to be an owner rather than a lender.
 Hold a diversified portfolio, avoid market timing, and fine-tune allocations at
extreme valuations.
 Invest in private markets that have incomplete information and illiquidity to
increase long-term incremental returns.
 Use outside managers except for all but the most routine or indexed
investments.
 Allocate capital to investment firms owned and managed by the people
actually doing the investing to reduce conflicts of interest.
Financial Crisis of 2009
Endowment
Hedge
Funds
Domestic
Equity
Bonds
Foreign
Equity
Private
Equity
Real Assets
Cash
Harvard
18%
11%
11%
22%
13%
26%
-3%
Yale
25%
10%
4%
15%
20%
29%
-4%
Princeton
24%
7%
2%
12%
29%
23%
2%
Stanford
18%
37%
10%
N/A
12%
23%
N/A
Average
Education
Endowment
22%
22%
12%
20%
9%
14%
2%
Average Asset
Class Return
for the Period
-20%
-27%
6%
-31%
-50%
-47%
2%
The Breakdown – What Happened?
 Fundamental illiquidity – universities were keeping little of




their money in cash
Median decline in return for all endowments in fiscal 2008
was 19%
For the same period, the S & P 500 declined 26.2%
Large Ivy League endowments fared worse
It got so bad that universities were forced to borrow
How Bad Was It for Ivy Endowments?
Extreme Events in Investment History
 Black Monday (1987)
 The Gulf War (1990)
 The Mexican Crisis (1994)
 widely known as the Mexican peso crisis or the Tequila crisis, was caused by the
sudden devaluation of the Mexican peso in December 1994
 The Asian Crisis (1997)
 a period of financial crisis that gripped much of Asia beginning in July 1997, and raised
fears of a worldwide economic meltdown due to financial contagion
 The Tech Bubble (2000)
 aka the dot com bubble
 9/11 Terror Attack (2001)
 The Credit Crisis (2008)
 the threat of total collapse of large financial institutions, the bailout of banks by national
governments, and downturns in stock markets around the world. In many areas, the
housing market also suffered, resulting in evictions, foreclosures and prolonged
unemployment.
Lessons Learned by Harvard
 • “On the topic of limited partnerships, we also intend to continue to reduce
uncalled capital commitments to real estate and private equity fund managers.
Our uncalled capital commitments at the end of fiscal year 2010, were $6.6
billion, down from over $11 billion two years ago.”
 • “We have attended closely over the last two years to liquidity [emphasis
added], capital commitments and risk management….”
 • “We also need to be mindful that our portfolio, while large, still operates
under liquidity constraints [emphasis added] and spending demands that are
greater than they were 5-10 years ago. The endowment now funds 35% of the
total University budget.”
 • “Can our strategies and insights be improved? Yes. We learned some specific
lessons over the last two years about keeping control of our capital and being
prepared for unexpected market conditions.”
Lessons Learned by Yale
 • “Prudent investors maintain sufficient liquidity to meet the full range of
portfolio commitments, which, in the case of an endowment fund, include
annual spending distributions and contractual commitments to external money
managers.”
 • “Even with a zero allocation to cash in the portfolio, investment holdings
generate a fair amount of natural liquidity. For instance, bonds pay interest,
stocks pay dividends, real estate produces rents, energy reserves provide
returns on capital as well as returns of capital (through depletion), and private
equity partnerships distribute proceeds from realizations.”
 • “Liquidity matters, even to portfolios with modest spending requirements and
long-term horizons. By putting in place mechanisms to tap a variety of internal
and external sources of liquidity, endowment managers provide the means for
educational institutions to satisfy the full range of portfolio commitments.”
Lessons Learned for All
 Modern portfolio theory and asset allocation are not dead. Alternatives
can and do play an important role in a well-constructed and welldiversified portfolio.
 The difficulties of the large endowments don’t reflect a breakdown of
the principles of asset allocation; rather, they reflect failure of
endowment managers to properly diversify and plan for extreme events.
 Endowments must model and prepare for extreme events, evaluate
whether the classification of their assets genuinely reflects true
diversification, and perhaps most importantly, appropriate a much larger
portion of their portfolios to cash and other liquid assets.
So Now What?
Investment Policy – Key Elements
 A basic investment policy:
 Identifies the assets available for investing;
 Defines general investment objectives;
 Sets asset allocation parameters (e.g. diversification);
 Clarifies the organization’s tolerance for risk (does this by defining
required rating)
Hedge Funds, Private Equity, and Leveraged Buyouts –
Unlocking the Mystery of Wall Street: Financial Literacy for
Non-Profits
Thank You
Gregory J. Muth MPA, MS