Institutional cuts to PE: A mixed bag?

Shedding $800m of a $30bn private equity portfolio hardly screams abandonment. But the brand behind it is one the world listens to. It is similar to the nervousness that spread through the global private equity market when last year the world called for the end of the endowment model of investing. Shockwaves were sent to institutional investors across the globe, many of whom promptly ‘reviewed' their private equity strategy. Several, including some of the US's largest pension funds, have since announced marked decreases in private equity investment.

Interestingly, two of the hardest hit – Yale and Harvard – are increasing and maintaining their allocations, respectively. In fact in September, Harvard's investment company, HMC, hired an equity team from a hedge fund to expand its internal platform.

What do they know that others don't?

Plenty. "Yes, there were steep losses recently. But look where Yale and Harvard were in 1990 and where they are today," points out Harvard Business School's Josh Lerner. "Even taking into account the recent losses, they're still way ahead of where they'd have been if they'd just held stocks and bonds. Reverting to a more traditional method of investing would have saved some of the downside, but it also would have meant they'd have forgone much of the upside."

A problem may have been that in fact too many people adopted the endowment model precisely as it was heading for its most difficult period. "In the run up to the crisis, many lost sight of risk and liquidity and instead ended up chasing returns, thinking that they could look like Harvard or Yale, and earn comparable returns – when in fact very few institutions have the financial resources that come close to those of these institutions," points out Keith Luke, managing director of Commonfund. "This is pretty common human behaviour, but the consequence was that too many institutions took on too much risk and had too little liquidity to withstand the left tail risk events of 2009."

Cash ‘n carry
In addition to the need to stick it out, another lesson which has yet to be fully learnt is that some underlying assumptions of the endowment model may need to be re-examined – namely, the one that deems cash low priority. So keen were some Ivy Leagues to prioritise alternatives, many had negative cash positions in 2008 and 2009, with Yale's at -3.9% in 2008 and Harvard's -5%.

In its annual report, Yale states: "Even with a zero allocation to cash in the portfolio, investment holdings generate a fair amount of natural liquidity. For instance... stocks pay dividends... and private equity partnerships distribute proceeds from realisations."

In theory. However, the reality has been that equities struggled to pay dividends in the last couple of tumultuous years, and that private equity firms too provided very limited distributions to LPs – exacerbating their liquidity issues. Harvard has since announced it will increase its cash position to +2%.

At the end of the day, Ivy Leaguers are smart cookies. So it is interesting that while many institutional investors begin decreasing their private equity allocations, Harvard is maintaining its (at 13% AUM) and Yale increasing its from 21% to 26%.

This is prudent. Lerner says: "In the aftermath of the 1990s real estate bubble, a number of the most established endowments increased their allocation to real estate. This proved a lucrative decision. Now some, like Yale, are increasing their allocation to private equity because they believe it is a great time to invest: when lots of money is flowing into this asset class, it's the worst time to invest. Now as others exit, the time to invest is likely to be good."

This is part of a feature that first appeared in unquote" Private Equity Europe's February 2011 edition.

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