FINS3623 - Yale Case Summary PDF

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Case study summary of Yale Investment...

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Questions 1. What explains the differences between its strategy in private equity with that in other asset classes (e.g., real estate)? How has the investment Office decided when to make private equity investments? 2. How has the Investment Office made international private equity investments? What explains the differences between the performance of its international and domestic private equity investments? 3. How is the private equity industry changing? How could Swensen’s private equity strategy go wrong? 4. Should the Investment Office shift this private equity strategy? Question 1: 

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Private Equity is an import element of Yale’s Portfolio o Investor since 1973 o Repeated investments in partnerships formed by a select group of organizations o Emphasis on value-added strategies o Strong focus on alignment of incentives Yale has achieved spectacular success in Private Equity… o 31% over 29 years – well above benchmarks o Success in VC, buyouts and Oil and Gas But they have concerns about future o Recent Fund Influx: o Private pension funds in 1980s o Public pension funds in 1990s o Private equity pool has expanded from $4bn in 1980, to ~$300bn in 2004 o Funds much larger – market is more crowded o This could inflate deal values and reduce returns

Yale has generally followed a strategy of: 

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Equities o University outlays are primarily salaries o Inflation risk a concern, could erode purchasing power  Equity offers better protection against inflation? Diversification o Limit exposure to any single asset class o Avoid timing short-term market fluctuations o Exception is persuasive case regarding misvaluation Market Efficiency o Seek to put money to work in inefficient markets o Interquartile performance range greater in less liquid markets o Is this sufficient to determine market inefficiency and support Yale’s strategy?  Probably not! But, given Yale’s strategy of selecting managers with valueadding skills and if there is persistence in managers performance, this variation might imply skill. It is likely not sufficient to interpret the range in performance as market inefficiency, however. External Management o External managers given autonomy to implement strategies as they see fit

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Managers are chosen after analysis of abilities, comparative advantages, performance and reputation Significant focus placed on aligning incentives of managers with Yale Significant focus on structuring external management contract to mitigate risk (e.g separate accounts)

Question 2: 

Efficiency (PE vs Liquid Market Strategy) o Yale has no external managers for government bonds as they believe little to no ability to outperform the market (i.e no alpha); so why pay fees? o In equities, focus is on small-caps and less efficient markets o Significant ability for PE (buyout and VC) to outperform (greater interquartile returns spread) o But, is there persistence in returns? Will good managers last period be good managers this period? o Yale focus on managers who improve operations of business rather than simply financially engineer returns, giving them greater confidence on persistence in performance

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Manager profile (PE vs Real Estate Strategy) o Yale has strong relationships with key managers who generate high returns o Yale is often constrained in their investment in best performing funds o Yale focuses on consistency so they are not reviewed as “unreliable money” and can continue to access high performing funds o In Real Estate, managers are often not well known relative to PE managers Yale engages o This is due to inability to appropriately align incentives with larger real estate asset managers  Note the heavy focus Yale places on alignment of incentives o Yale’s recent paring back of portfolio here suggests less focus on reputation as reliable LP with Real Estate

Question 3: 

Manager Selection o Similar to domestic PE, Yale has focused heavily upon incentives of fund managers o This has limited their foreign PE exposure due to many international managers being subsidiaries of larger financial institutions o Similar to domestic PE, Yale analyses careful the track record of fund managers o In less developed markets, it is difficult for Yale to evaluate the track record where managers may have exited less deals o Corporate governance issues needed to be overcome in international markets  “A Brazilian firm tried to take 30% of a deal as its “fee”.”

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Comparison with Public Markets o In emerging public markets, there existed attractive opportunities with reasonable liquidity o Did private equity investments in those markets generate sufficient incremental returns over those in public markets to compensate for:  The incremental illiquidity of private equity investments  The incremental fees paid to private equity managers  The incremental risk of private equity investments over public equity investments o Recall the original strategy with private equity related significantly to exploiting inefficiency: if other asset classes exhibit this internationally, they may be preferable

Question 3: Some examples:

Theme

Implication

Expanding PE industry

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More competition Relaxation of fund incentives Relaxation of fund covenants Lower quality deals

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Past returns cannot be replicated Lower (negative) returns

Disintermediation in PE investment

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More competition from Crowd funding, Incubators/accelerators, Angel networks

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Lower (negative) returns Lower fees & carry

Growth opportunities in international PE markets

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Yale at an informational disadvantage Swensen’s emphasis on incentives means that some emerging market funds are not compatible (lack of proper incentive structure)

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Yale may miss opportunities in emerging markets due to investment philosophy

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Consequence for Yale

Question 4: Whilst it is difficult to make a definitive judgement based on the case alone, some considerations are: Yale’s current strategy    

Building relationships with top-tier VC/PE funds (utilizing the Yale alumni network) Focused on incentives of fund managers Focus on domestic (informational advantage) Avoiding market timing

They could shift to a focus on emerging markets:   

This would require a shift in strategy relating to incentives and informational advantage Potentially higher returns Lack of proper incentive structure

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Difficult to develop quality relationships and evaluate the track record of managers May end up doing some bad deals

They could try to take on other strategies: 

Market timing o May improve returns if it can be done successfully o May incur unnecessary switching costs if done unsuccessfully, and diminish their reputation as “reliable money” from some GPs...