Private equity funds fail to make the grade for Yale endowment

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Yale’s endowment invested heavily in hedge funds and private equities

A plan by David Swensen, chief investment officer of Yale’s endowment, to prune the university’s exposure to private equity for the first time in eight years is causing a stir.

Indeed, enthusiasts with an interest are offering their thoughts on the logic behind Mr Swensen’s move to tweak the $20.8bn fund’s target allocation to private equity funds from 35 per cent to 31 per cent in the current fiscal year.

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The consensus among the tea-leaf readers is that Mr Swensen wants to wipe a bit of illiquidity risk off the counter at a time when returns on stocks are outpacing those provided by a number of private equity funds.

Put simply, Mr Swensen, who still devotes more of Yale’s money to private equity investments than to any other asset class, is not reaping enough of a profit to justify the risk Yale takes when it is locked into private equity funds for a period of years.

“They likely want less illiquidity and less lock-up exposure,” says John Griswold, executive director of the Commonfund Institute, the investment management group.

Mr Swensen will also cut Yale’s exposure to property, another asset class prone to bouts of illiquidity, from 22 to 19 per cent. He will slightly increase targeted investments in natural resources (a projected 8 per cent allocation); non-US equities (11 per cent); and absolute-return strategies (20 per cent), which aim to profit in bull and bear markets alike.

Jane Mendillo, who oversees rival Harvard University’s $32.7bn endowment as the president and chief executive of Harvard Management Company, appears to embrace a similar view of the private equity sector.

In a note sent last month, Ms Mendillo voiced her displeasure at Harvard’s efforts to win big in the sector. In the note she describes the performance of the university’s private-equity portion (venture capital is included), which returned 11 per cent in the year until the end of June, as “fair”.

It was a “strong nominal return [for private equity], but well below the return on public market equity, and only slightly above our benchmark”, she wrote.

“When we invest in private equity, we lock up Harvard’s money for multiple years. In exchange for that lock-up, we expect to earn returns over time that are in excess of the public markets – an ‘illiquidity premium’.”

She added: “Over the past 10 years however, our private equity and public equity portfolios have delivered similar returns.”

In a show of the university’s intention to revive its private equity portfolio by finding the “very best managers”, it has named Lane MacDonald, a Harvard alumnus and former partner at Alta Communications, a private equity firm, as its endowment’s new managing director for private equity.

Moaning about the performance of private equity by prominent managers such as Ms Mendillo comes as the relevance of the so-called Yale model is being called into question. This is the popular theory Mr Swensen pioneered that suggests endowments should move aggressively into alternative investments such as hedge funds, private equity and property to diversify portfolios.

An emerging problem with the Yale model, according to its critics, is that it is far harder to make money from investing in alternatives now than when Mr Swensen began pushing the idea in the 1980s.

“That whole trade is crowded now. It’s way harder to make money in alternatives,” says Robert Seawright, chief investment and information officer for Madison Avenue Securities, the broker dealer and investment advisory firm.

Mr Seawright argues that the Yale model is inappropriate for smaller endowments. “The evidence is pretty clear that unless you have the ability and the resources that Yale does, it is problematic to expect that you could get the level of performance that Yale has.”

Indeed, earlier this year, when a group of analysts came together to discuss the strengths of the Yale endowment model – calling their efforts The Portfolio Whiteboard Project – they came to the conclusion that “no single investment approach suits all organisations”.

Even over the long term, the returns provided by university endowments with more than $1bn do not look better than those offered by the S&P 500 index.

In the last three years, the mean for the 56 endowments tracked by Cambridge Associates, the investment consultancy, came to 10.5 per cent against a 17.4 per cent return from the S&P 500. Over the past decade, the performance of the endowments improved a bit, gaining 8.4 per cent on average against a 5.9 per cent return by the S&P 500.

The returns provided by Yale and Harvard’s endowments of 12.5 per cent and 11.3 per cent respectively also failed to beat the S&P 500 in the last fiscal year.

Mr Seawright argues that such comparisons are unfair, as endowments are longer-term investments and their diversified portfolios serve a different purpose than index trackers.

“Endowments are perpetual investments,” he says. “I don’t think Yale or any other endowment should be criticised for not beating the S&P in any given year.”