The Case is about the decision of the Yale Investments Office whether to continue to allocate the bulk of the university’s endowment to illiquid investments–hedge funds, private equity, real estate, and so forth. Important is to consider the risks and benefits of a different asset allocation strategy. Before the choice between different subclasses, e.g., between venture capital and leveraged buyout funds would be analyzed it is advantageous to get first background information. Effective management of a university endowment requires balancing fundamentally competing objectives. On the one hand, the University requires immediate proceeds to support the current generation of scholars. On the other hand, investment managers must consider the needs of generations to come. In order to understand the behavior of the Yale University would be a view thrown in the past helpful. In the 20th Century the growth of the Yale endowment was accelerated rapidly due to enormous bequests and big investments in equity. In 1930 equities represented 42% of the Yale endowment this was in comparison to other universities (11%) very high.
Because of the Great Depression severe erosion of its endowment was avoided in 1930, but in the end of this decade reduced a treasurer of Yale the share of equities. The reason was that higher taxes expropriate profits. He assumed that bonds better perform than stocks. For the next two decades, treasurer selected individual bonds & high yield or income orientated stocks for the portfolio. In the 1950s and 1960s this strategy was less useful for the bull market so they had to change their policy. First Yale decided to increase substantially the university´s exposure to equity investments and second Yale decided to contract out much of the Portfolio Management function to an external adviser. The plan was the external company Endowment Management & Research Corporation (EM&R) would function as a quasi-independent external firm & would be free to recruit additional clients. At the same time Yale would be its largest client and would have priority over other clients. But the expectations were not realized. So in 1979 due to the plummet of the inflation-adjusted Endowment value by 46%, terminated Yale its relationship with EM&R.
They followed working with a variety of external advises in its envolving asset management framework. Now, David Swensen was in 1985 hired to the Head of Yales´s Investment Office and the whole Investment Committee consists of a well-diversified team. Besides Yale could develop its investment philosophy from 5 principles. These are the principles: 1). Strong believe in equities. Equities are a claim on areal stream of income while the bonds have low expected returns but poor performance with uncertain inflation. The long-run returns of equity is tremendous than the long-run return of bond. This principle is reasonable for the equity can bring risk premium return for the portfolio.2.) Diversify Portfolio. Risk could be more effectively reduced by diversify the portfolio to different kinds of asset classes rather than pile on the single asset class. With the diversified strategy, the portfolio can prevent extremely loss when the market is down unexpected.3.) Seek opportunities in less efficient markets. There are far greater incremental returns in nonpublic markets with incomplete information and illiquidity through selecting superior managers.
Therefore, The Investment Office devote large portion of fund in illiquid investments. This principle sounds good but the Investment Office should pay attention to potential large risk.4.) Utilize outside managers for all but the most routine or indexed of investments. For the outside managers can be given considerable autonomy to implement their strategies with relatively little interference from Yale. However, it’s not an easy task in finding excellent managers in foreign equity market, especially in emerging market. Also, we will face the problem of interest conflict between Yale and the external managers.5.) Focus critically on the explicit and implicit incentives facing outside managers. Because rarely asset management business had good incentive alignments built into typical client-manager relationships.
It is necessary for Investment Office to construct good innovative relationships and fee structures with various external managers to consist the manager interests with Yale’s. Yale´s Investment Committee annually reviewed its endowment portfolio. For the choice between different asset classes we will consider the actual allocations in 2006.
*2006 (current Target allocation)*Considered only the last 2-3 years The consideration of the expected returns and risks from its current allocation and compared them with those of past Yale allocations and the current mean allocation of other universities reflected the need of university to diversify its holdings.In August 2006, Swensen and Takahashi believed that they probably wanted to continue with investments in less efficient markets. But Private investments were important in contributing to Yale´s highest returns. How should Yale allocate its new commitment? Compelling category to invest in Venture Capital/ Real estate/ Real assets, choices today? Mix between new groups and established organizations? Should Yale expand its international program to include a greater emphasis on Asia and other emerging markets?
Advantage DiadvantagePrivate Equity(Venture Capital/ Real estate/) -consists with investment philosophy-long-term relationship with limited number of organizations-Excess Returns (15,4%) by portfolio´s active Manager-greater exposure than other schools-scale on which PE operated-VC& midmarket BO-relationship with key manager – competitive advantage -Yale has understanding of the private equity process -boom and bust cycle (high risk)-defections of key personnel-manager risk-avoid VC: obtaining access to the best firms nearly impossible-Yale should invest with a top-tier firm International PE Funds -good, because of the increasingly competitive in the U.S market-they have general partners on site (e.g China) -more planning-subsidiaries or affiliates of large financial institutions-difficult to evaluate foreign private equity organizations and selecting manager
Real Assets (Real Estate/oil and gas) -interesting set of investment opportunities-avoid mortgages and other debt -only attractive if they could find the right manager with the right strategies and the right incentive structures-transaction fees or fees based upon assets-less attractive oil-and-gas, because it is difficult to find well-designed oil-and-gas partnerships Foreign equity/ Emerging markets -Undervalued securities-provide portfolio diversification-grow rapidly, provide opportunities for active managers to earn superior returns- 7 active emerging market manager in the PF-(well diversified)
-Slow development of institutional investing-Leading foreign manager appeared to work for large institutions -returns low correlation with those of the US-link between growth and profitability is weak Bonds / Foreign fixed-income securities -low risk -Skepsis, if returns are enough for compensation of default risk and callability of corporate issues-low expected returns perform poorly Approach (regard to the table above):Yale should stay committed to private equity (e.g high returns, Yale´s hedging strategies reduces risk in private equity, enough important benefits to being in the private market). Besides it consists with the investment philosophy (principles). They should diversify portfolio with international private equity funds, it allows to break into new markets and get new opportunities, key managers are on site.
Yale shouldn´t invest in real estate (Real estate industry is dominated by firms that were compensated through transaction fees or fees based upon assets under management. These firms have every incentive to keep their investors´ capital toed up over long periods of time. Besides less attractive is also oil-and-gas industry not enough knowledge and key manager). They have 7 key manager in the Portfolio for emerging markers, so it is a great opportunity to expand in emerging markets and find undervalued securities. The link between growth and profitability, which is weak can change with good manager decisions. They could diversify the risk with the high Private Equity returns.