Monday, 13 August 2012 - 20:00

 

Charts

Yale Endowment: 2011

The annual Yale Endowment Report is a must read at Seed, and this year is no different. Each year we attempt to gain insights into why this is one of the best performing institutional portfolios in the world, and see if there are any nuggets of wisdom that we can use in the management of the funds and portfolios that we manage on our clients’ behalf.

In summary, the Yale Endowment is a $19.4bn endowment that currently provides over one third of Yale’s annual revenue, while preserving (and growing) the real purchasing power of the capital base for use by future generations. In many ways high net worth individual and family trust investment plans are similar to endowments, particularly where there is a desire to leave a legacy. In years gone by we have looked at how having a well defined drawdown methodology will not only help extend the capital’s life, but that there are also ways to ensure that the annual changes in the drawdown amount aren’t too volatile.

One aspect in this year’s report that struck me was the endowment’s large allocation to illiquid assets. As at the end of 2011 nearly two thirds of Yale’s endowment was invested into illiquid assets! I then took a look back at how this allocation differs to their endowment in 2001, and also compared to the average educational endowment.

The chart below shows how Yale has increased its allocation to illiquid assets over the past decade, and how the average educational endowment holds even less illiquid assets than Yale did 10 years ago. Illiquid assets are defined as private equity, real estate, and natural resources. Quasi-liquid assets are made up of absolute return strategies (typically hedge fund type investments), while liquid assets are those that trade on public exchanges, i.e. equity and fixed income.

The first key observation is that the Yale Endowment hasn’t done well because it invested into illiquid assets per se. Illiquidity in itself doesn’t generate returns, but good illiquid investments have the ability to generate exceptional performance. Illiquid assets by their very nature are often uncorrelated to more liquid assets (as there isn’t an active market that is overly influenced by the prevailing sentiment) and investors are often rewarded with an illiquidity premium, but these asset classes typically require more in depth due diligence and larger investment minimums.

Another observation is that while their allocation to illiquid assets is high, they still have enough invested in liquid strategies to be used to fund the university’s drawdown requirement. The defined drawdown process results in approximately 5% of the endowment being drawn on an annual basis. With this percentage being fairly static, the investment team is able to maximise their return profile. Too often we see individual investors that require a large percentage of their assets to be readily accessible as they are unsure of their income requirement, and by doing so require a large portion of their assets to be invested in low yielding highly liquid strategies.

With 36% of the endowment in liquid and quasi-liquid strategies, in a worst case scenario (i.e. when the illiquid assets can’t be sold) the endowment will be able to fund approximately 7 years of income requirement before having to start liquidating the illiquid assets. In the normal course of business they will ensure that the level of illiquid assets doesn’t rise above a specific pre-determined maximum weighting.

On a practical level many investors are large shareholders in the businesses that they run. For these clients their illiquid assets are locked up in their shareholding, and for them it is important to build up an asset base outside of the illiquid private equity in order to ensure that they will be able to generate sufficient liquidity should the need arise.

Within Seed’s Funds there are a few relatively illiquid strategies which are able to generate outsized returns for the levels of risk assumed. It is important to balance the enhanced expected returns with sufficient liquidity, because the surest way to destroy capital is being forced to liquidate an illiquid asset.

Take care,

Mike Browne

www.seedinvestments.co.za
info@seedinvestments.co.za
021 914 4966

Mon, 13 Aug 2012

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