Are Endowments At “Peak Private Equity” ?

Harvard’s Lesson in Private Equity
The fascination with complex alternative investments is fading.
Bloomberg, October 17, 2016.

These are tough times for university endowments — there’s the difficulty of producing consistent results; the questionable love of investments in hedge funds and private equity amid high fees and underperformance; and the challenge of having to respond tocompeting constituencies. These issues are not going away anytime soon. If anything, they are becoming more pronounced and complicated in a time of low interest rates and volatile markets.

In that context, this doesn’t come as shocking news: Harvard Management Corp., the entity that runs Harvard University’s endowment, is considering the sale of part of its private-equity investments.

HMC declined to comment, so we don’t have precise numbers on exactly what funds it is looking to sell. What we do know is that, according to HMC’s most recent annual report, about 20 percent of the $35.7 billion it manages is in private-equity assets. Those holdings returned 2.6 percent during the past fiscal year, a bright spot relative to the endowment’s overall minus 2 percent performance.

Harvard’s endowment report made it clear that a reorganization of the private-equity holdings was in the works:

We are actively concentrating the portfolio by scaling our commitments to a core group of top managers, and selectively adding new relationships to address gaps in the portfolio.

Presumably that doesn’t just mean sector gaps but gaps in performance, since a 2.6 percent annual return isn’t really something to boast about.

Harvard isn’t the only underperformer among college endowments. As Bloomberg News reported last month, “College endowments are poised to take the worst slide in performance since the 2009 recession.” Preston McSwain of Fiduciary Wealth Partners asked if college endowments in their effort to beat the competition, are “ending up with portfolios that are so complex that they’re hard to get their heads around.”

That complexity is problematic. It is expensive and it leads to poor understanding of the total endowment holdings, all of which hurts returns. As Charlie Munger has observed, “Simplicity has a way of improving performance through enabling us to better understand what we are doing.”

That competition for bragging rights among alumni is what is driving some of the increased complexity in these endowments’ investment decisions. And yet it is the complexity itself that almost ensures that the funds generate disappointing results.

Consider as evidence HMC’s plan to sell part of its private-equity investments. The buyer of this is most likely another private-equity fund. This circle of trades — a private-equity investment doesn’t work out as planned and gets sold at a healthy discount to another private-equity fund — makes one wonder who benefits from these transactions. The sure winners on this trade are not the endowments (who may win or lose depending upon how things work out), but the private-equity managers themselves.

It wasn’t that long ago that so-called alternative investments were all the rage among endowments as equity markets meandered in the mid-2000s and interest rates headed to zero amid the financial crisis. Private equity was one of the main beneficiaries. Bloomberg Gadflyreported that assets under management by private-equity firms ballooned from $580 billion in 2000 to $2.4 trillion by June 2015. Investors were lured by the inherent characteristics of private equity — low correlations with equity markets, modest volatility and good performance.

However, those reasons sound remarkably similar to what was said in the past about hedge funds: Well-publicized performance led to biginflows led to underperformance led to big outflows.

In the hedge fund world, there is only so much alpha — or market-beating returns — to go around. There are comparable constraints on private-equity returns, driven by similar factors. It shouldn’t come as a surprise that as private equity became huge, returns suffered.

University endowments have a history of plowing into asset classes late in their cycles. The planned shift by HMC might suggest private equity has peaked and become so overwhelmed with capital that performance suffers. It wouldn’t be the first time.

Originally: Harvard’s Lesson in Private Equity