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									Aug 30th 2007
From The Economist print edition


A complex system, but a simple problem
ILLIQUIDITY—the difficulty of selling assets at a reasonable price—is at the
heart of all financial crises. The market turmoil of the past few weeks is
proving that maxim, albeit in novel and interesting ways.

The financial system has been transformed over the past 25 years, with the
emergence of new investors (hedge funds and private-equity groups) and
new instruments (derivatives and structured products). But what look like
incredibly sophisticated strategies on the surface can still be very simple at
heart. Investors have been doing what banks have done over the centuries,
borrowing short and lending long. Or, to put it another way, they have
borrowed in liquid form and invested the proceeds in illiquid assets.

Most of the time this strategy works, because illiquid assets offer a premium
return to compensate for the higher risk. It has been given an extra kicker
over the last two decades by the “Great Moderation” in the global economy.
Falling inflation and steady growth have meant that periods of economic
turmoil have been shorter than expected, causing less pain to investors.

But the markets never rest. As more money flowed into risky assets, the
excess yields on offer were reduced. Investors were tempted to use more
and more borrowed money to enhance the returns. That left them very
vulnerable to any abrupt change in sentiment.

The problems of structured investment vehicles (SIVs) are a case in point.
These are specialist funds, kept separate from their parent company's
balance sheet, that invest in illiquid assets, such as securities backed by
subprime mortgages. They funded those long-term investments by
borrowing short-term in the money markets, in the form of commercial
paper. Other investors were happy to buy that commercial paper because it
was “asset-backed”, in the form of the mortgage debt.

Now investors, worried about the value of the mortgage-backed debt, are
boycotting the commercial paper. The amount of paper outstanding has
fallen by $181 billion in two weeks, according to Société Générale, a French
bank. This has driven the vehicles on an increasingly desperate hunt for
funding. On August 28th Standard & Poor's, a rating agency, downgraded
one SIV, Cheyne Finance, and gave warning that it may be forced to sell all
of its assets.

The effect is rippling through the system. First, forced liquidations push
down the price of assets, hitting confidence further. Second, some of these
SIVs were either set up by, or have back-up lending facilities with, banks.
So banks are ending up back on the hook. Third, these unwanted assets are
putting additional strain on banks' balance sheets, which forces them to
restrict their lending. It all adds up to a classic liquidity crisis.
Two new academic papers suggest that such crises may be inherent to
financial markets. In the first*, the academics link the liquidity of the
markets to the ability of traders to get funding. In some circumstances (like
now), this system becomes destabilising as traders are forced to put up
more capital to fund their positions. This causes them to sell assets, sending
prices down further and prompting lenders to demand pledges of even more
capital. This is a description of the liquidity trap that doomed Long-Term
Capital Management, an American hedge fund, almost a decade ago.

The second paper† suggests that traders face “Knightian uncertainty”, or
risks that cannot be measured. When liquidity appears to be limited, those
faced with this uncertainty fear the worst and try to hang on to their capital,
exacerbating the lack of liquidity in the markets.

This uncertainty may have been increased by the lack of transparency in
the modern financial system. No one is sure who owns what, so investors
are treating all counterparties with suspicion. And the much-touted
advantage of the system—the way that risk has been dispersed—looks less
convincing now that banks have been saddled with the cost of funding
private-equity buy-outs and SIVs.

In the past, liquidity crises have been solved by the emergence of a
confident buyer with deep pockets, such as John Pierpont Morgan in
1907. But who could it be this time? Pension funds and insurance
companies no longer have the flexibility, while hedge funds are
facing tighter funding and the prospect of redemptions. That leaves
the sovereign wealth funds of China and the Middle East. But even if
they want to buy in bulk, do Western governments want to let them?

* “Market Liquidity and Funding Liquidity”, by Markus Brunnermeier and
Lase Heje Pedersen, June 2007.

† “Collective Risk Management in a Flight to Quality Episode”, by Ricardo
Caballero and Arvind Krishnamurthy, August 2007.
On a gambling expedition
Aug 30th 2007 | HONG KONG
From The Economist print edition
Constraints at home push China's banks into risky foreign assets

SOME people had long suspected there were booby traps waiting to be sprung
inside the Chinese banking system. But few thought they would be tripped by
problems far away from China.

So it caused considerable surprise on August 23rd when Bank of China, one of the
country's biggest lenders, revealed that it held a $9.6 billion exposure to securities
backed by American subprime mortgages—albeit most of them highly rated. No
other bank in Asia has admitted to such a large investment in that segment of
America's fast-deteriorating mortgage market. Subsequently, China's two other
large, publicly listed institutions, ICBC and China Construction Bank, each disclosed
subprime holdings above $1 billion.

For Bank of China in particular the financial hit could be severe: 18% of
shareholders' equity, were the entire investment to prove worthless. That is
unlikely, but so is the prospect that the $151m the bank put aside will cover
potential losses.

Optimists, including the Chinese authorities, played down the seriousness of the
problem. Chinese banks are hugely profitable: among the biggest banks, earnings
are growing by more than 40% a year and non-performing loans have shrunk from
about a quarter of the total several years ago to less than 4%. To them, that
makes the subprime losses look more like an inconvenience than a calamity.

The numbers, however, should not be belittled. Bank of China's investments in
ropey American mortgages are almost as much as the amount it raised in a Hong
Kong share offering last year. The reason it took such a gamble may well reflect
some of the problems of managing a bank's balance sheet in China. Share offerings
have raised lots of capital; but bankers have only a few years of experience making
complex (possibly cross-border) asset-allocation decisions, and domestic securities
markets are still primitive, with few investment opportunities.

Government efforts to constrain a lending boom have put further pressure on
Chinese banks. They must keep twice the share of risk-weighted assets as reserves
that they did four years ago, 12% compared with 6%. On those reserves, banks
receive a measly 2% in interest. Meanwhile Moody's, a ratings agency, reckons that
the loan-to-deposit ratio for Chinese banks is a modest 68%. For Bank of China the
number is lower still, about 60%.

This poses a huge investment challenge for the banks, because lending should be
their most lucrative business. Typically, they earn 7% on a loan, compared with 3%
paid to depositors. Alternative assets are in short supply. The domestic bond
market is thin (ironically because the Chinese government wants to restrict
competition for banks). No wonder they have hunted abroad for highly rated,
lucrative assets whose risks they may not have fully understood. Such are the traps
that await any institution with too much money and too little to do with it.
The ivory trade
Jan 18th 2007 | NEW YORK
From The Economist print edition




What makes America's colleges such clever investors?

AMERICA is the home of the efficient-market hypothesis, which says financial
markets have become so keenly contested that it is impossible for investors to keep
beating them. Yet the very universities that peddle this theory so confidently also
gleefully undermine it by doing precisely that: over one year and over ten, their
endowment funds beat the S&P 500 and hammer most other institutional investors,
including pension funds.

The final figures for the most recent fiscal year will be out next week. But according
to preliminary numbers from the National Association of College and University
Business Officers (NACUBO) and TIAA-CREF, a financial-services group, university
endowments made an average return of 10.7% in the year to June 30th 2006, net
of fees and expenses.

The biggest endowments are big investors: between them, Harvard and Yale have
some $50 billion, around one-seventh of the total. They tend to do better than their
smaller peers and pretty much everyone else. Indeed, these eggheads even beat
the quants. Endowments larger than $1 billion returned 15.2% on average last
year, more than the main hedge-fund index (see chart). The best-performing
endowment in 2005-06, which belonged to the Massachusetts Institute of
Technology, gained a handsome 23%. That put it a whisker ahead of Yale's
(22.9%), run for more than 20 years by
David Swensen.

Endowment managers would no doubt like
to claim this is all down to skill. But they
do enjoy certain advantages over their
rivals. In principle, their investment
horizon lasts not weeks, months or years,
but forever. Their capital is extremely
patient. Each endowment has a single
client—itself—that needs to extract only a
small sum annually to keep the wheels of
scholarship turning. Therefore, unlike
pension funds, they do not have to fret
about matching assets with liabilities. This
means endowments can tolerate lots of
volatility, which in turn allows them to
make, and stick to, contrarian bets. They
have been “incredibly gutsy” in going
against the grain, says Will Wechsler of
Greenwich Associates, a financial-services
consultancy. Perhaps they can stay
solvent longer than the market can stay irrational.

A second advantage is the university environment. “Whereas pension trustees are
naturally risk-averse, universities are all about innovating, financially as well as
intellectually,” says James Walsh, who runs Cornell's $5 billion endowment.
Investment constraints are kept to a minimum. Alumni with Wall Street experience
are encouraged not only to donate money but also to sit on investment
committees. Many are happy to oblige. “This gives us access to minds we couldn't
otherwise afford,” says Mr Walsh. The brainpower on tap at the university itself is
not always as useful. According to one former Harvard official, its endowment fund
has done so well because it has avoided taking advice from the economics faculty.

Put these factors together, says Mohamed El-Erian, Harvard's endowment chief,
and you have a recipe for “thinking more boldly than the pack”. America's
endowments were among the first to look beyond the staid mix of domestic
equities, bonds and cash. The idea they helped develop in the 1970s and 1980s—
deemed eccentric at the time—was to break the portfolio into a mix of standard and
“alternative” assets, as uncorrelated with each other as possible so as to spread
risk. This strategy is sometimes referred to as “portable alpha”.

Their early moves into hedge funds, venture capital, private equity, property,
distressed debt and the like brought outsized profits. Universities and foundations
have also benefited from geographical diversification, especially into emerging
markets. Foreign equity was their best-performing asset class last year, making
24.7% according to a survey by the Commonfund Institute, which manages pooled
investments. Endowments have also revolutionised commodities. By making a
killing in “hard” assets like timber in recent years, the universities have helped to
turn them from industrial assets to financial ones in investors' eyes. Harvard keeps
three lumberjacks on its team, the joke goes.

Sweating as they swot

Indeed, for university endowments to call all of these assets “alternative” is
something of a misnomer. It is assets such as government bonds, once safely in
the mainstream, that must fight for their place in university portfolios. Today the
typical large endowment has 41% of its holdings in assets other than shares, bonds
and cash, says NACUBO. In the past couple of decades, illiquid investments, which
are less efficiently priced than liquid ones, have rewarded those brave enough to
buy them. Thus big, bold endowments have thrived by resisting what John Maynard
Keynes—a proponent of asset diversification—called the “fetish of liquidity”.

Will university endowments continue to defy the ivory-tower theorists? Don Fehrs,
head of research at Evanston Capital Management, a hedge fund—and a former
head of Cornell's endowment—thinks it is becoming harder for them to maintain
their advantage because, predictably, copycat investors have piled into areas they
once had largely to themselves.

The biggest endowments now employ dozens of bright sparks to look for promising
new pastures. Some have even sent scouts to developing countries. Others are
hoping to stay ahead by handing large sums to bright but untried managers. They
are spending less time on broad asset allocation, and more on trying to pick
winners within each class.

This is a trickier exercise, but they may have no choice. Simply putting 20% into
hedge funds is no longer enough. The big test of their prowess will come when lax
credit conditions tighten. John Griswold of Commonfund thinks that some
investment committees, stuffed with alumni, may be starting to lose track of the
risks their endowments are taking.

All endowments are finding it harder to hold on to their best people. Although a few
high-fliers, such as Mr Swensen, are content to forgo the vast salaries they could
earn at private firms—top endowment chiefs rarely get more than $2m a year—
many have been tempted away as portable alpha of a different kind.

Harvard, Stanford, Cornell and Duke have all lost their bosses over the past year
and a half. After 15 years in the job, Harvard's Jack Meyer tired of the hostility
students and professors showed towards his highly paid (and highly successful)
managers. He quit and set up a hedge fund, taking more than 30 of his colleagues
with him. Stanford's Michael McCaffery left after failing to persuade the university
to let him manage private money alongside the endowment. These defections have
left quite a few vacancies at the top.

Nevertheless, the endowment model continues to win plaudits—and to attract
imitators abroad. As Japan loosens its investment rules, its university presidents
are said to be looking very closely at the “Yale model”. In Britain, Cambridge
University has persuaded Mr Swensen to sit on the committee overseeing its £1.2
billion ($2.35 billion) central endowment. Despite the resistance of otherworldly
dons, it recently became the first British university to hire a City financier to run its
fund. The university's vice-chancellor, Alison Richard, was previously provost of
Yale, where she gained a “powerful understanding” of what a well run endowment
can do. Profits trumping profs on the banks of the Cam: that really would be an
investment coup.
The secret of Yale's success
Oct 4th 2001 | NEW YORK
From The Economist print edition


The university's endowment fund has done remarkably well

GIVEN the wretched recent performance of stockmarkets, any diversified fund that
has made money is doing well. For months, there have been rumours of something
particularly unusual going on at Yale University's $11 billion endowment, which has
long pursued a quirky strategy that largely shunned publicly traded shares for
illiquid assets such as venture capital.

Yale sometimes trumpets the results of its endowment. This year it was unusually
quiet. It has recently made available, but only on request and without comment, its
performance for the year ending June 30th: up by 9.2%. That is half its average
rate of return achieved over the past decade—but it is arguably a far more
impressive number. According to Morningstar, a research firm, in the same period a
broad portfolio of American shares would have lost 15%, and of global shares 24%.
American mutual funds that invested in both shares and bonds lost, on average,
2%.

David Swensen, who manages the endowment, was quite chatty about the
composition of the portfolio before the start of the fiscal year, revealing that along
with a huge stake in venture capital, it was heavily invested in junk bonds and
emerging-market securities. All three categories have been beaten up this year. So
how did Yale do so well?

Market rumour has it that Mr Swensen hedged his huge venture-capital holding by
placing a massive short position on publicly traded technology firms, which he kept
during brief rallies before cashing in. Mr Swensen declines to talk about this. It is
easy to see why, if the rumours are true. Short-sellers were unfairly blamed for the
crash of 1929 and are under attack again. Mr Swensen may fear a backlash. For an
Ivy League university that is the president's alma mater to seem to be betting
against America may rub folk up the wrong way. Some bets may even have been
short positions in firms run by Yale alumni.

Yale's minimalist reporting standards save Mr Swensen from daily public scrutiny
and criticism. That may have made shorting easier, and Yale richer.
An F in Logic
By letting its money-management chief leave, Harvard risks paying more, getting less
Barrons – nov/05

By ANDREW BARY

Wanted: "an extremely experienced investment professional with extensive knowledge of all
asset classes and investment strategies" willing to endure "ongoing harassment and ridicule
from envious, ignorant, abusive alumni" at Harvard.

-- A mock help-wanted ad distributed by friends of Jack Meyer

JACK MEYER'S CRITICS at Harvard might be book-smart, but they certainly aren't Street-
smart. In fact, they might eventually look like dunces for driving away the man who probably
made a greater financial contribution to the university than anyone else in its 369-year history.

Partly due to a flap over what some thought was excessive pay, Meyer will leave Harvard
Management, the in-house investment firm he headed, after the end of Harvard's current fiscal
year in June -- despite years of soaring outperformance. And he'll be accompanied by two of
Harvard Management's biggest remaining stars, Dave Mittelman and Maurice Samuels, low-
profile bond managers who've amassed a great record over the past decade. They'll join a new
investment firm that Meyer is forming. Apt to be a very hot ticket with savvy investors, it could
easily draw $5 billion.

Under Meyers' stewardship over the past 15 years, the school's endowment more than
quadrupled, to $22.6 billion, versus No. 2 Yale's $12.7 billion. Based on that accomplishment,
university officials should be measuring the 59-year-old portfolio manager for a statue in
Harvard Yard. In announcing Meyer's departure, the school's usually outspoken president, Larry
Summers, merely said he was "grateful" for what Meyer and his staff had done. Sort of like Red
Sox fans saying Curt Schilling pitched fairly well last fall.

Harvard is apt to pay more and get less as it increasingly relies on outside investment
managers. When Meyer goes, the share of the endowment run by Harvard Management will
                           drop to about 20%, down from a peak near 85% in the mid-1990s.

                            Recreating an organization like the one Meyer developed in the
                            'Nineties will be virtually impossible. Talented investment managers
                            now have more opportunity to make big money at hedge funds
                            without dealing with the furor that comes with the annual revelation
                            of pay packages at Harvard Management -- a result of the school's
                            status as a nonprofit entity.

                            If the lion's share of Harvard's endowment were shifted to outsiders,
                            that could produce sizeable job losses at Harvard Management,
which now employs 175 people. Indeed, the buzz in Boston is that Meyer's departure marks the
beginning of the end for the organization in its current form.

In a brief interview with Barron's, Meyer, a Harvard Business School graduate, said of the pay
flap: "It will be nice to step back from that." Referring to his new fund, he added: "I have one
good chapter left, and this should be it."

Samuels and Mittelman were Harvard's two best-paid managers in the past two years. Each
earned $25 million in Harvard's latest fiscal year, ended June 30, 2004, based entirely on his
investment performance. Meyer, who earned $7 million last year, consistently defended the pay
packages against critics, including some Harvard professors, saying the university was getting a
bargain, compared to what it would have paid outsiders for similar performance. Because other
big universities, such as Yale and Princeton, farm out the bulk of their endowments to outside
managers, their fee levels are rarely disclosed -- or challenged.
One sign of the times is Harvard's recent decision to invest $500 million in Eton Park, a new
hedge fund formed by Eric Mindich, a former senior executive at Goldman Sachs. That fund has
a steep fee structure -- a 2% annual base and 20% of any profits.

If Eton Park produces a 10% gross return, Harvard would pay nearly $20 million annually to
Mindich, to get just 6% after fees. That would be lower than the 10% historical average return
for stocks. Why not simply buy an S&P index fund and, say, pay an annual fee of $250,000 for a
$500 million investment?

In contrast, Samuels and Mittelman made big bucks only by outpacing the market. They got
about 10% of any gains above their benchmarks' return.

During the past 10 years, Mittelman produced an average annual return of 14.9%; and
Samuels, 16.9%, versus benchmark returns of 6% to 8%. Both pursued complex arbitrage
strategies that often involved leverage. Mittelman managed about $2.5 billion; Samuels, $1.2
billion.

Meyer played a key role in generating Harvard's results by identifying and nurturing top talent
and by helping shape the endowment's asset allocation -- now light on U.S. stocks and heavy in
such areas as commodities, private equity and timber.

"Jack did a brilliant job of steering Harvard Management through good times and bad," says
Morgan Stanley strategist Byron Wien, a Harvard alumnus and fund raiser. "He was creative in
the use of alternative-investment strategies, such as investing in timber, and he provided an
environment for talented managers to thrive."

In the past 10 years, Harvard's endowment generated an average annual return of 15.9%, three
percentage points better than the average of the 25 largest university endowments and four
points more than the S&P 500. Yale's endowment was the only one in the top group whose
returns beat Harvard's in the past decade, reflecting David Swenson's brilliant stewardship.

Harvard's performance translated into $12 billion of added value, relative to a benchmark of big
institutional portfolios tracked by the Trust Universe Comparison Service. With Harvard
spending about 5% of the endowment annually for university programs, that added value means
$600 million more in annual income.

Consistency and discipline were hallmarks of the Meyer regime. Harvard Management matched
or beat the average of the top 25 endowments in each of the past 12 years -- and did so without
any major investment blowup, despite often using considerable leverage. Meyer's streak
arguably is better than Bill Miller's 14-year record of beating the S&P 500 with the Legg Mason
Value Trust.

Meyer was criticized in the late 1990s because Harvard's performance was trailing the stock
market's. His faith in diversification, however, was vindicated after 2000, when a bear market
descended on Wall Street. Over the past five years, the endowment has returned 11.8%
annually, versus the S&P's negative 2.5% yearly return.

Meyer was reluctant to pay the steep fees commanded by hedge funds, believing most wouldn't
generate commensurate performance. Instead, he created a hedge-fund environment within the
Harvard group, whose managers sought undervalued situations and arbitrage opportunities in
global stock and bond markets.

And yes, Meyer implemented the pay scheme in which his managers earned modest base
salaries but got a chunk of the profits they produced above a benchmark. To protect Harvard,
he instituted a "clawback" feature -- part of a manager's bonus is kept in reserve and can be
forfeited for future poor performance.
Summers, a former U.S. Treasury Secretary, is believed to have strong views on how the
endowment should be run. Among strategies it could follow would be to make asset-allocation
bets, such as shifting the weighting of stocks and bonds if, say, equities look more appealing.
Meyer did little of that.

But, regardless of what Harvard does, it's blown its best option: keeping Jack Meyer.

+++++++++++++++

A+ Performance

Harvard boasts the largest endowment of any university in the nation, in part because of the
outstanding performance turned in by its in-house portfolio managers...

                                             Annual Returns**
School                                        1-Year          10-Year       Size (bil)
Harvard                                        21.1%            15.9%          $22.6
Yale                                             19.4                16.8        12.7
Stanford                                         18.0                15.1        10.0
Princeton                                        16.8                15.5         9.9
Columbia                                         16.9                11.6         4.5
25 Largest Endowments*                           17.1                12.8       ——



...who have racked up impressive gains in many investment sectors.


Harvard's Holdings                          Annual Returns**                 Weight In
By Sector                                   1-Year         10-Year          Endowment
Domestic Equities                            22.8%            17.8%                 15%
Foreign Equities                               36.1              8.5                     10
Emerging Markets                               36.6              9.7                      5
Private Equity                                 20.8             31.5                     13
Hedge Funds                                    15.7              n.a                     12
High Yield                                     12.4              9.7                      5
Commodities                                    19.7             10.9                     13
Real Estate                                    16.0             15.0                     10
Domestic Bonds                                  9.2             14.9                     11
Foreign Bonds                                  17.4             16.9                      5
Inflation-indexed Bonds                         4.2              n.a.                     6
Total Endowment                                21.1             15.9          105%***



*Median return is shown. **Period ended June 2004.

***Equals 105 because of slight leverage.

Sources: Harvard; Yale; Princeton; Stanford; Columbia
Harvard endowment posts strong positive
return
Harvard University’s endowment earned a 23.0 percent return during the fiscal
year ending June 30, 2007. With FY07 being one of the best performance years
since the inception of Harvard Management Company in 1974, the overall value
of the University’s endowment grew to $34.9 billion.

The continued strong returns reinforce the endowment’s critical support for
Harvard’s academic programs and mission. In the 2007 fiscal year, distributions
from the endowment financed almost one-third of Harvard’s operating budget,
or over $1.1 billion.

Harvard’s reliance on support from its endowment has increased in recent
years. In fiscal 1997, endowment income provided 21 percent of Harvard’s total
income; in the 2007 fiscal year, that figure was 33 percent. In dollar terms, the
distributions from the endowment have tripled in this 10-year period.

The distributions from the endowment fund specific activities donors have
endowed over time, including financial aid, faculty salaries, and facilities
maintenance. For example, endowment income supports Harvard’s student
financial aid programs, which permit the University to admit qualified students
regardless of their ability to pay. From fiscal 2001 to fiscal 2007, for example,
scholarships and awards to students from University funds increased by over 94
percent, to $302 million from $156 million. Endowment dollars distributed for
overall Harvard programs rose more than 70 percent during the same period,
from $615 million to $1.04 billion.

Mohamed A. El-Erian, the President and CEO of Harvard Management Company
(HMC), noted that "the dedicated hard work of my HMC colleagues was again
critical in meeting the institution’s goal of preserving and enhancing the real
value of the University’s endowment, thereby helping to fund a host of activities
that are central to Harvard’s ability to maintain a leadership role across a wide
range of educational endeavors." He observed that “during a period of
organizational transition, the strong investment performance was accompanied
by important institutional gains, including the completion of the effort to rebuild
HMC’s portfolio management platform.”

In addition to significantly outpacing the University’s total return target, HMC
significantly out-performed its internal benchmark. Furthermore, the fiscal 2007
performance compares favorably to that recorded by other large investment
management institutions. Specifically, the endowment’s return of 23.0 percent
out-performed the median for the 151 large institutional funds as measured by
the Trust Universe Comparison Service (17.7 percent), as well as the 20.9
percent that marks the top 5 percentile.

The 23.0 percent return for the last fiscal year brings the endowment’s
annualized 10-year performance to 15.0 percent and the 5-year annualized
return to 18.4 percent. Since its inception, HMC has averaged an annualized
rate of return of 13.3 percent.
The endowment’s total value is affected by several factors each year, including
investment returns, new contributions, and the annual payout for University
programs. The endowment stood at $29.2 billion on June 30, 2006.

The endowment is not a single fund, but around 11,000 individual funds, many
of them restricted to specific uses such as support of a research center or the
creation of a professorship in a specific subject. The funds are invested by
Harvard Management Company, which oversees the University’s endowment,
pension, trust funds, and other investments at a cost less than outside
management.

Harvard seeks to spend about 5 percent of the endowment annually on
University programs. Each school within the University uses a combination of
income from investments, gifts from fundraising efforts, and tuition to cover the
cost of educating students. Tuition from Harvard College, for instance, covers
only about two-thirds of the total cost of a Harvard education.
Why endowments do it better

The investment success enjoyed by the endowments at US universities Yale and
Harvard when it comes to private equity is widely known. But just how successful a
breed of private equity investor these two Ivy League institutions represent is a less
familiar fact.

According to new research undertaken by leading private equity scholars Josh
Lerner and Wan Wong of Harvard Business School and Antoinette Schoar of the
Sloan School of Management at MIT*, endowments are the best investors in the
asset class - by miles.

Having analysed a sample of 7,587 investments by 417 LPs in 1,398 US private
equity funds raised between 1991 and 2001, the three academics found that funds
invested in by endowments show an average IRR in excess of 20 percent (!), way
more than funds backed by public pension schemes (7.6 percent), insurance
companies (5.5 percent), advisors and funds of funds (minus 1.8 percent) and
banks (minus 3.2 percent).

This is a startling outcome - not least given how stark the wide range of results
appears. What is more, the authors show that the findings are statistically robust
even after adjusting their calculations for a number of important factors that
arguably give endowments an advantage in the asset class: that they tend to have
spent more time in private equity than other investors; that they are willing to take
more risk; that they invest in the class primarily in order to achieve superior
returns (and not, as banks for instance do, for strategic reasons); and, crucially,
that endowments are more likely than many of their LP peers to have participated
in the more successful vintages during the ten-year period under investigation.

So why are endowments getting so much more performance out of private equity
than other types of investors?

Lerner, Wong and Schoar point to a number of reasons, of which two are
particularly interesting. Number one, they assert that endowments derived
their entire alpha from investing in early- and late-stage venture capital
funds. Money they put into buyout partnerships on the other hand, whilst at least
not producing a negative return, singularly failed to move their needles.

Number two, and this is possibly the most telling insight that this study provides,
endowments are better than anyone at selecting and then sticking with the
most successful managers from one fund to another. The research shows, for
a start, that endowments were less likely than other types of investors to reinvest
in any given partnership. Moreover, where they did decide to recommit to a
manager, the subsequent performance of that manager's fund was considerably
better than those GPs they chose to ditch.

Crucially, the reinvestment strategies pursued by other types of LPs were found to
be much less successful. As the authors comment, endowments appear to
"proactively use the information they gain as inside investors, while other
LPs seem less willing or able to use information they obtained as an
existing fund investor."

This is serious food for thought, particularly at a time when LPs the world over are
trying to identify the crème de la crème among funds coming to market in 2005
and 2006. Many of these LPs are determined to reduce the number of funds in
their portfolios going forward. Placing bigger bets with fewer GPs means there will
be even less margin for error - so the scatter chart logging the investment
performance of different LPs could become even widely spread.

As an investor in private equity, you will need to work hard to make these
investment calls well. Better due diligence should help deliver the information
needed. The art (not the science) is to then use that information wisely - something
the endowments have clearly learnt.

* Smart Institutions, Foolish Choices?: The Limited Partner Performance Puzzle, by
Josh Lerner, Antoinette Schoar and Wan Wong, Harvard and MIT working paper,
2004. Readers can find a more detailed discussion of the paper in the November
issue of our sister publication Private Equity International - out now.

								
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