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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