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The
“alternative investment strategy,” which
this year has led many university endowment funds to the brink
of ruination, was pioneered by David Swensen, Yale’s
chief investment officer since 1985. A PhD in economics and
lecturer in finance, Swensen achieved such consistently high
returns for Yale’s endowment fund up until 2009, that
the strategy he outlined in his 2000 book Pioneering Portfolio
Management: An Unconventional Approach to Institutional Investment,
was widely imitated by other university endowment funds. Indeed,
at the height of the bubble it is difficult to find a single
major University that was not dancing to Swensen’s tune,
and, for all practical purposes, it not all replaced the traditional
strategy of dividing a portfolio mainly between blue-chip
bonds and equities, nut served as the new paradigm for University
investment officers.
The heart of his strategy was to drastically reduce the allocation
for bonds, equities, and cash, and substitute for them a portfolio
of illiquid investments that included participations in leverages
buy-outs, hedge funds, and stockpiles of physical assets.
He argued in his book that such illiquid investments carry
less risk and more potential for high returns than stocks
or bonds.. His case was that since endowment funds did not
have to concern themselves with withdrawals for taxes or redemptions
to their investors, they did not need the liquidity of the
major stock and bond markets and could therefore avoid losses
from short-term fluctuations.
Swensen most persuasive point was his own remarkable performance
at Yale. By 2000, he had put most of its endowment fund in
illiquid investments. While high-flying US stocks collapsed
in the Internet bubble of 2000-2001, Yale’s endowment
fund made money as its assets rose in value, and it outperformed
almost every other major endowment funds (many of which lost
money), as its Yale’s President, Richard Levin, pointed
out. Following Swensen’s path, all the Ivy League schools,
including Harvard, with the world’s largest endowment,
moved their portfolios into alternative investments. By 2008,
Not only did they invest most of their money in alternative
investments but, as the price of entry into private equity
and real estate funds, they made unfunded commitments to add
capital equal to slightly over 25 percent of their entire
fund, if called upon to do so by the fund managers.
How illiquid were these alternative investment? Consider,
for example, the private equity funds in which they became
limited partners in order to participate in leveraged buy-outs
and other such deals. The general partners, who were private
equity houses such as KKR, typically required that endowment
funds make a multi-year commitment, which could be as long
as ten years, not withdraw their investment. They often also
required a commitment to furnish additional funds in the response
to their “capital call.” If all went well this
additional money would come from the profits that the endowment
funds earned in the deals, but if all went badly they would
be liable for raising the money . Harvard, with about $4 billion
to private equity deals in 2008, is a case in point. Since
it had an unfunded commitment of approximately $1billion for
capital calls, it attempted to reduce its exposure by selling
some of its private equity participations to so-called secondary
funds. But even offering to sell them at as much as a 35 percent
discount, it found no buyers.
Hedge funds, another main channel for alternative investment,
provide somewhat better liquidity, but they also can restrict
withdrawals by “gating” their fund. Harvard, for
example, invested a half billion dollars in a hedge fund called
Sowood Capital. But in July 2007 the hedge fund got caught
in a complex series of arbitrage trades involving credit default
swaps that wiped out over half its capital and, when it couldn't
meet lenders' demands for more collateral, it turned over
its remaining asserts, including what was left of Harvard’s
money, to another hedge fund, Citadel Investment Group, which
then suspended redemptions.
The other alternative investment channel in the Swensen strategy
is physical assets including huge tracts of land and real
estate. Turning such assets into money can, however, be difficult.
Consider what happened to CalPERS, the giant pension fund
of the California Public Employees’ Retirement System,
when it sunk part of its portfolio investment in undeveloped
residential and timber land in Arizona, Florida, and California.
As home prices fell in 2007-2008, CalPERS found was unable
to sell properties for anywhere near the price it paid, and,
as it borrowed to finance these purchases, it wound up with
took a 103% loss.
Illiquidity was not a problem when notional prices went up
in the boom years. When the bubble burst in 2008 however,
they proved to be largely a mirage. Endowment funds losses
over $50 billion at least call into question Swensen’s
strategy of diversifying into illiquid assets. As it turns
out, the three main pillars of the diversification–
private equity participations, hedge funds, and physical assets–
depend on the same variable: credit. When credit became more
less available in the financial meltdown, these alternative
investments rapidly shed their notional value.
What of the Pied Piper himself? Yale announced a 13.4 percent
losses in Yale’s $22.5 endowment fund in October 2008
in its “marketable securities.” But that $3 billion
loss did not include its illiquid investments, including those
outsourced to private equity funds, that constituted over
two-thirds its portfolio. Yale President Levin explained,“
it is difficult to know exactly how much the University has
lost in investments that are not traded on a daily basis and
are difficult to value with precision.” Swensen shrugged
off that problem in February 2009 by saying: “ We only
mark the portfolio to market once a year, on June 30,”
and added that even this annual reckoning is done merely for
financial disclosure and future planning purposes . If so,
such willing blindness means that despite a year of massive
write-down at private equity houses, Yale will not know how
it has done on two-thirds of its portfolio until June 30th
2009. Even if his once-a-year claim is mere hyperbole intended
to show his calm in the eye of a financial storm, it reflects
the disconnect between the notional and realizable value of
illiquid assets.
The real issue underlying the Swensen strategy is what is
the purpose of an endowment fund. If it is to gamble on creating
a jackpot large enough for a university to finance large scale
future expansion, Swensen’s strategy may make sense
since it promises long-term profits. But if its purpose it
to assure an institution’s continuity in bad as well
as good times, the strategy may be inappropriate, especially
if in times of crises, when other money-raising is diminished,
a university may have to borrow enormous sums to meet capital
calls from private equity houses . Unfortunately, such considerations
of purpose tend to be drowned out by the alluring; sweet-sounding
tune of a Pied Piper.
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