Case Analysis

Yale University Investments Office: August 2006

Executive Summary The Yale Investments Office has managed the universitys endowment well, growing it at average annualized rate of 15.4% over the last 20 years. It has helped pioneer the extensive use of private equity and other alternative asset classes to produce superior growth and increase the diversification of its assets. The Investments Office reports to the universitys Investment Committee, many of whose members are from the world of investment management. The Investments Office is responsible for managing the endowments fixed income assets, setting the endowments investment philosophy and strategies, identifying and selecting top notch investment advisers, determining the target asset allocation mix for future investment periods, and hedging against overexposure in its private equity investments. Its unique investment philosophy combined with long-term, high-quality staff allows it to maintain long-term mutually beneficial relationships with its investment advisers. It is recognizing some changes in the private equity industry that has been an integral part of its long-term success that is causing it to consider its current investment strategies and use of domestic and international private equity investment funds. The endowments chief rationale behind using private equity and alternative investment classes revolves around their investments in less efficient markets, where their particular knowledge and expertise allows them to earn excess profits by taking advantage of the information asymmetries in those less efficient markets. Regarding whether the Investments Office needs to make any changes to its investment strategies and allocations, we determined that there will still plenty of opportunities for the endowment to benefit from private equity investment funds. Therefore, we do recommend some changes to its current allocation. Our review of the domestic and international private equity industry and the Investment Offices investment strategy should continue to be a viable strategy. However, the endowment would benefit from increasing its allocations in foreign equity, real assets and private equity. Also, it should stop holding fixed income investments and just keep the liquidity in an equity-income fund. Finally, it should reduce its allocations of US equities and absolute return funds. The results are presented in the table below.
Asset Class US Equities Foreign Equity Fixed Income Equity-Income Real Assets Private Equity Absolute Return Expected Return Expected Risk Sharpe Ratio Target Allocation 9.00% 20.00% 0.00% 4.00% 30.00% 25.00% 12.00% 14.42% 14.12% 0.987

Introduction Yale University began its endowment in 1818 to fund its theological programs, acquire land for future growth and construct new facilities for current growth. Through the benevolence of many wealthy and well off alumni, Yale continued to receive gifts for its endowment and eventually required professional investment management. In the modern era of its endowment, it has grown from $1.3 billion to over $18 billion by the end of fiscal year 2006. The endowment has been well run and has done exceptionally well under the leadership of David Swensen since 1985. However, after 20 years of spectacular growth in an investment fund that routinely spends around 4% of its value annually, its disciplined endowment management are reevaluating some of the strategies that have helped the fund outperform all of its peers for the past 20 years to accommodate the changing landscape of investing and asset management.

Yale University Investments Office The Yale University Investments Office (Office) was formed in 1979, after the dissolution of the relationship between Yale and the Endowment Management and Research Corporation that had originally been formed to manage the Universitys endowment. The end of that relationship was precipitated by huge losses to the value of the endowment during the turbulent economy of the 1970s. The University began to directly oversee the investment managers responsible for growing and protecting its endowment. The University recruited the first and only head of the Office, David Swensen, from Lehman Brothers. Swensen focused on bringing in highly qualified and competent staff to help build the organization. The purpose of the Office under Swensen was to set the endowments investment policies and rigorously select the investment advisers who would manage Yales endowment accounts. The Office reports to Yales Investment Committee, which is also comprised of many Yale alumni who were accomplished investors in their own rights. The Office was so successful that its value contributed to the highest credit ratings for the University, which facilitated lower borrowing costs on new facilities. Investment Philosophy The Offices investment philosophy was driven by five investment principles. The principles can be listed as follows: 1. 2. 3. 4. 5. Strong belief in investing in equities Hold a diversified portfolio Seek opportunities in less efficient markets Use outside managers for most investments Dont ignore the explicit and implicit incentives of investment managers

The first principle is based on Swensens (who has a PhD in economics) research that public and private equity were a good investment because they provided returns that were significant, even when adjusted for inflation. However, investment in bonds produced predictable streams of income that could be quickly eroded by inflation.

Plus, the long-term returns from equities were superior to that of bonds or other fixed income instruments, even corporate bonds, as shown in the chart on the following page.

14% 12%
AnnualizedReturn

AnnualizedAssetReturns 1925 2005

10% 8% 6% 4% 2% 0% LargeCompany Stocks SmallCompany Stocks USTreasury Bonds USTreasuryBills

AssetClass

The second principle requires a diversified portfolio a basic tenet of portfolio management. This minimizes risk for the endowment by limiting its exposure to any particular asset class. This will reduce the cyclicality in the annual returns for the endowment. The endowment would avoid trying to time the market to produce returns. The third principle emphasizes seeking returns in less efficient markets, which would be one way to produce excess returns because of the lack of publicly available critical information for decision making. Swensen based this on the slender box plots for the performance of the middle 50% of investment managers in different asset classes. In inefficient markets the middle 50% was much wider than in traditional investment asset classes. To Swensen, this meant that there were more opportunities to obtain excess returns. It also meant that the endowment would be less liquid than others. The fourth principle was based on Swensens thought that the Office could do a much better job of picking good investment advisers than it could at managing investments. The Office would focus its time and energy of developing relationship with investment managers that displayed the kind of investment discipline and innovation that was thought necessary to meet its objectives. The Office would only manager indexed or fixed income investments. The fifth principle is closely related to the fourth principle. Swensen felt that there were inherent conflicts of interest in many investment management firms, especially those that were owned by larger financial institutions. Additionally, the Office only wanted to work with investment managers who were willing to abide by a different compensation structure one that rewarded them for producing returns rather than rewarded them for managing an ever-increasing amount of assets.

Asset Allocation The Office used mean-variance analysis to help it make asset allocations. However, it did put limit some of the possible solutions by placing limits on the proportion of the endowment that could be invested in any particular asset class to ensure a certain degree of diversification. Otherwise, its optimization model would leave out whole asset classes. An example of the limitations of computational approaches is that private equity was expected to produce nearly twice the return as US equities with only 50% increase in risk. Therefore, the model would say not to hold any US equities. Some of the asset classes were simply considered as hedges against a worstcase market melt own. The limits were also necessary because the Office knew that the relationships between different asset classes change over time, so it could not completely rely on historical relationships. The asset class limits were also an acknowledgment that there were limits to the Offices ability to assess future risk. That also meant that the Office ran five- and fifty-year Monte Carlo analyses for downside risk in proposed portfolios. The success of the Office resulted in increasing spending rates several times between 1992 and 2004.

RiskReturnRelationshipsforDifferent AssetClasses
15% 12% 9% 6% 3% 0% 0% 5% 10% 15% Risk() 20% 25% 30% 35% USTBills USEquity RealEstate (REITs) International Equities SmallUSStocks PrivateEquity EmergingMarkets USTBonds

As the Office become more knowledgeable and comfortable with private equity and other less common asset classes, it increased its diversification by asset class and increased its allocations to classes that produced higher average returns. The change in asset allocation from 1985 through 2006 can be seen in the chart below.

AnnualizedReturn(r)

YaleEndowmentAssetAllocatinbyClass
100 90
PercentofEndowment

80 70 60 50 40 30 20 10 0
1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Absolutereturn Privateequity Realassets Cash Bonds Foreignequity Domesticequity

Year

Bonds and Cash The bond investments and cash holding investments are used as hedges against market volatility. The Office manages bond investments internally with a target weight of 4% with a maximum allowable weight of 5%. The market for bonds was considered to be so efficient that there was no advantage in having an external manager. Swensen also wasnt confident that corporate bonds provided enough compensation for default and callability risk. He also felt that bond fund managers were incentivized to take greater risks than they should. Any cash held over and above the amount to be spent by the Yale was kept to a negligible portion of the endowment and was slated to be allocated to zero. Domestic and Foreign Equity The Office had over 25% of the endowment allocated to publicly traded equities, which was substantially lower than its peers. The Office decided that passive index investments were not going to be a part of its equity portfolio. In general, the average individual investor is told to just invest in index funds for the long haul. However, the Office felt that it could do better by employing a handful of high-performing active managers who were disciplined and fundamentals-based. Managers who could not clearly articulate their strategies or attempted seat-of-the-pants market timing or contrarian strategies were also overlooked. Equity investment managers had to coinvest and accept compensation incentives consistent with making Yales endowment larger before they collect fees for anything except their operating costs. The Office also preferred funds that were not owned by large financial institutions. Foreign equity allocations were comparable to domestics with a higher allocation target because they represented opportunities in some of the fastest growing economies in the world, such as Asia, Latin America and Eastern Europe. However, it was more difficult for the Office to find active managers that met its requirement because many of the domestic active

managers had been recommended by investment committee members or other trusted sources that it did not have overseas. Foreign equities also increased the diversification of the endowment because they were poorly correlated to US equities. Real Assets Real assets constituted about 27% of the targeted portfolio for the endowment and are among its most illiquid. The real assets the Office invested in are categorized as real estate, oil and gas fields, and timberland. The Office had a long investment horizon and could afford to take advantage of deals that may take several years to produce high returns. The Office avoided real estate related investment vehicles that contained mortgages or other similar derivative investment tools. The Office purchased of oil and gas fields with a focus on enhancing the operations to produce superior returns. Plus, it was much less risky than exploration, which is a hit or miss type of investment. Timberland investments focused on sustainable harvesting of softwood and hardwood forestland in the US. Absolute Return The Office allocates 25% of its funds to absolute return funds. Absolute return funds are a broad group of funds that attempt to produce a positive return regardless of the performance of the market as a whole. However, the funds use a wide variety of strategies that employ stocks, bonds, commodities, short selling, futures, options and other derivatives, arbitrage and anything else that a financial genius can devise. The Office categorized them as either event driven or value driven investments, where event-driven funds attempt to create profitable hedges of asset plays centered on events such as mergers or bankruptcies. Value driven funds sought mispriced securities to exploit. It includes many hedge funds and other potentially volatile funds. The Office sought to hedge its investment from capital flight by having separate accounts for its investments so that they could not be sold to provide capital for other investors cashing out during a market free fall. Private Equity The Office also allocated 17% of its portfolio for private equity funds, which engage in leveraged buyouts, mezzanine financing, venture capital and company acquisition. The Office used the same approach for private equity fund managers as it did with its equity managers. It selected managers who were disciplined and had a value approach to their investments. Most of the private equity managers were recommended by members of the Investment Committee. Managers who were focused on value did not need to find the next deal in order to create value for their investors the way leveraged buyout firms did when they flipped a company for a profit. Significant returns in value could be earned over long periods of time by improving the operations of a company. Compensation of private equity managers was in alignment with Yales investment needs, not the managers compensation needs. The Office paid its private equity managers enough in fees to cover their operating costs and the fund would receive the rest of its profit not from managing a large amount of assets, but from

producing real returns for the endowment. In a few cases, where the fund was sufficiently well-run, the Office would make exceptions to its compensation philosophy. Therefore, private equity managers were incentivized to make the endowment money rather than just sit on a pile of assets where their management fees would make them money while the client lost value. And, if they could not grow the funds under management, they would not make a profit. This was one of the means of controlling private equity managers from taking unnecessary risks because they were putting their profits at risk, as well. The Office used a different strategy with its private equity manager than it did with other asset classes. The firms it used in private equity were usually established top-rated firms in their industry who had the discretion to invest the funds in whatever way they saw fit because their underlying investment strategies were compatible with the Offices investment philosophy. For foreign equity managers, it had to take a little more risk in that it did not have extensive reliable contacts for recommendations and it kept its foreign equity investments in a handful of emerging markets that the managers could not deviate from. In real assets, the Office primarily used small, new or unheard of firms for real asset investment or management companies whose investment strategies and operational expertise were complimentary to the endowments investment goals. The real asset firms went along with the Offices compensation structure. Real property that was invested was derived from specific types of real property, such as buildings that were in depressed areas, shopping centers that needed reconfiguration, or highly illiquid developable land. The focus on out of favor segments of real estate was a specific strategy that the firms could not deviate away from. Finally, the Office kept investing with its private equity managers, even when it did not want to because it wanted to be a reliable partner who kept most of its funds invested instead of cashing out whenever it didnt like something. For other asset classes, it would simply cash out, if it felt the need to do so. The Office entered many of its earlier deals as a partner. It was sometimes approached by private equity firms to participate in their funds. For venture capital funds, they simply would not change the way they did business. So if the Office thought that a particular fund was an attractive investment, even with an unfavorable compensation structure, the Office would still decide to invest with a particular fund. However, if a fund significantly changed its strategy or compensation structure, then the Office would decide to no longer do business with that fund. Compared to the investment strategy with managers of other asset classes, if they did not adopt the Offices compensation structure or if they were connected to a larger financial institution, the Office didnt do business with them. Additionally, while the Office gave its private equity managers wide latitude in investments, it carefully tracked those investments to create additional hedging strategies with short sales and put options to create offsetting profits if a large equity holding suffered a price decline. Therefore, the Office hedged to prevent overexposure to any particular market, while it let the individual private equity managers make their decisions. It did not feel the need to hedge as a strategy with the other asset classes.

International Private Equity Investments. The Office sought to expand its private equity investments outside of France and the UK to emerging markets. There were fewer funds competing for deals. However, it made its international private equity investments while avoiding those funds associated with large financial institutions. Those types of arrangements also made it more difficult for the Office to assess their performance and record. Those made the Office consider looking at the global private equity funds of well-established US private equity firms. In the end, the Office was able to find a number of new emerging market funds that were better incentivized than the larger global funds because they were run by general managers who were not bothered by coinvestment or the Offices approach to compensation. They were run by experienced and hungry to take advantage of known opportunities. One of the noticeable differences between its strategy with domestic versus international private equity managers was that international private equity was primarily with smaller firms with favorable compensation structures. Also, there were more opportunities to produce excess returns internationally than in the U.S., where private equity was getting larger and larger with more firms pursuing the available deals. Past experience with international private equity had produced annualized average returns in the mid-20s, but the returns had been much more volatile and risky than those in the U.S. Performance Monitoring Because Yales endowment had an atypical asset allocation compared to other similar endowments and it had high investment goals, it could not settle for just comparing itself to similar endowments. Instead, it compared each asset class to a comparable index to make sure that each element of its endowment was producing satisfactory returns. The chart below shows how the Office compared to its indices.

FY2006YaleEndowmentPerformance
40.0% 35.0% 30.0% 25.0% 20.0% 15.0% 10.0% 5.0% 0.0% 5.0% Domestic Foreign equity equity Fixed Realassets Private income equity Yale2006 Return Benchmark Absolute return Total

Not only did Yales endowment outperform its respective benchmarks, but it also beat the performance of 99% of all large institutional investors. The endowments 15.4% annualized return over 20 years was nearly 4% greater than its peers and nearly 6% greater than all endowments. When compounded over 20 years that translates into an endowment that is twice the size as a similar sized one 20 years ago. The performance of the endowment has been such that it has experienced negatives only twice in the last 20 years. The Office also has equally impressive 10-year results, which includes the technology stock bubble bursting. Changes in the Private Equity Industry The Yale Investments Office had ridden private equity from its infancy until it became an investing juggernaut with more and more money being poured into its funds. The Office investment staff was becoming concerned about changes in the private equity industry. Not only was the money chasing it for higher returns. More investment managers and financial institutions were creating their own private equity funds for the higher management fees and greater management compensation. First, many private equity funds were incredibly large billions of dollars. However, the Office can continue to evaluate the performance of their private equity managers and continue to find more disciplined managers. There are only so many opportunities to invest in at a given time. An example of that is Fidelitys Magellan Fund, which had to stop taking money because of limited opportunities. It hit its maximum net assets under management at $119 billion. Swensen is concerned that they may pursue having large amount of assets under management that produce lower returns rather than pursue the high-return strategies that have served them well. Second, there is more competition to contribute money to private equity funds. Every major institutional investor has looked at the U.S. private equity market to gain higher returns. This includes overseas institutional investors, state pension funds (who are chasing returns to make up for underfunding) and some of the worlds newly minted multi-millionaires and billionaires, many of whom are in China. This could cause price competition for asset acquisitions and it became more difficult for the Office to get sufficiently large allocations to some funds because of the demand for them. It solved it in some case by seeding the start up of some funds, but then it accepted manager risk for having a large proportion of funds under management by one fund. The greatest risk that these changes in the private equity industry posed to Swensens strategy is that the autonomy that he has given private equity managers could create greater risk that is difficult to hedge, especially if some of its investments are in exotic investment vehicles that could be indirectly linked to some riskier investments. This is similar to the risk exposure that investors faced from AIG having sold so many credit default swap policies without setting aside money for future or potential claims, as a traditional insurer does. Also, the amount of the endowment in private equity could lead to lower diversification if too many private equity funds chase the same kind of opportunities. Missteps by fund management could lead to capital flight or total illiquidity of some investments. Investors in subprime mortgage backed

securities had to mark their investments down to zero because there was no market for those investment instruments, even though they were still paying interest to the eligible investment tranches. As beneficial as private equity has been for the Office, it has done very well, even if you exclude the returns associated with private equity, as shown in the chart below. More than 70% of the time, private equity causes the change in the value of the endowment to be greater than it otherwise would be. However, the differences in return are relatively small.

EndowmentAnnualReturnswithand withoutPrivateEquity
50.0% 40.0% 30.0% 20.0% 10.0% 0.0% 10.0% 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006

Returnw/PrivateEquity

Returnw/oPrivateEquity

Private Equity Considerations Although changes in the private equity industry require vigilance, private equity still provides certain benefits for the Office. It has delivered superior annualized returns for the Office and continues to beat the larger markets. The Office has strong working relationships with many of the best private equity managers that would be hard to duplicate if it backed out of private equity. Improving global capital markets, combined with emerging markets, provided many more opportunities for private equity to produce excess returns because new markets were less efficient than established markets. Future Investment Alternative Strategies The most serious decision that Swensen will have to make regarding the investment strategy of the Yale Investments Office is whether to continue in the direction that it has been heading or to adopt another approach, especially as it concerns private equity. There are a number of issues to be considered that could future alternative investment strategies the Offices investment horizon, regulatory issues that could affect its asset classes, return requirements and its risk tolerance.

Investment Horizon The Office is a long-term investor that can take into account shorter-term cyclical effects, such as the decennial recessions and market bubbles. For most bubble markets, except for the technology bubble, which was peddling worthless companies that never made a profit, history has shown that if investors had held onto their assets, they would have been better off than if they had sold them at a discount and then reinvested the proceeds. The Office has the capacity to take a long view. Tax/Regulation Issues There is talk in political circles of the President wanting to eliminate the tax advantages that private equity fund managers have over traditional investment fund managers. This primarily affects the compensation of private equity fund managers and hedge fund managers who pay much lower taxes on the carry portion of their compensation. If such a change occurred, it probably would have no effect on the number of private equity funds. The possibility of reforming the tax code could have a longer term impact because it will normalize the earnings of industries that benefit from subsidies, tax credits and favorable industry tax rates. That could lower the future profit margin rates of some companies, which could affect their valuations. Return Requirement Based on its efficient frontier for 2006, the Office wants to achieve real returns in the future similar to what it had accomplished in 1998, when it had a return above 14%. This would be comparable or just slightly higher than the real return achieved that year. Risk Tolerance The Office has high risk tolerance because it invests in atypical asset classes like real assets, absolute funds and private equity. However, that does not mean that it does not attempt to minimize its risk by having quality long-term relationships with an easy exchange of information and it keeps doing its own research on new investment opportunities and continues to look for the best performing and disciplined investment advisers. This doesnt eliminate risk, but it lowers it because its size makes the markets somewhat more efficient for it than it does for individual or small investors. Recommendations Given what is known about near-term possibilities in the U.S. and around the world, it would be prudent for Mr. Swensen to adjust his private equity strategy. The Office has done a great job of finding talented and consistent private equity managers. Even without private equity, the endowment has grown significantly. Therefore, we would recommend the following changes in the Offices investment strategies and allocations. 1. Increase allocation of assets invested in private equity. This also applies to international private equity. Overall, private equities have had a higher Sharpe ratio than U.S. equities. Therefore, a little added risk can produce a much greater reward. Also, as much as private equity has contributed to the growth of the endowment, it still would beat its peers without its influence.

2. Increase allocation of real assets. Although it would increase the illiquidity of the endowment, real assets provide certain long-term benefits. They can produce income even when the market value is down. All forms of real assets are under demand pressure from a growing U.S. population, so they should continue to outperform the market because the Office can wait until their disposition maximizes their return. Demand for commercial property in desirable areas, developable land, oil and gas and wood-related products are only expected to increase. Global and domestic oil and natural gas consumption are only expected to increase in the U.S. and globally. 3. Increase the allocation of foreign equities. Currently, the economic growth engines are overseas and the best way to take advantage of that is to be invested in those markets, where it is complementary to the Offices investment strategy. 4. Eliminate bond holdings for stable dividend paying stocks. The Office would be better off investing its funds in a high-quality equity-income fund because it would produce higher returns and have an upside in capital appreciation in exchange for the increased volatility. Many dividend paying blue chip stocks are stable with consistent cash flows and modest growth. Volatility aside, firms like McDonalds actually do better during recessions because they are cost competitive, which explains how their CEO managed to increase U.S. same store sales by 50% in 7 years. Many utilities are cash cows and are reliable sources of income. 5. Reduce holdings in absolute return funds. Many absolute return funds have high correlations to the stock market, which makes them slightly redundant and not as good for diversification as thought (Dan Jones, Investment Week, February 20, 2012). The same task of producing returns during a down market can be addressed by private equity funds.

Currentvs.Recommended AssetAllocation
35 30 25 20 15 10 5 0

AssetAllocation (%)

Domestic Equity 12.0 9.0

Foreign Equity 15.0 20.0

Bonds 4.0 0.0

Income Fund 0.0 4.0

Real Assets 27.0 30.0

Private Equity 17.0 25.0

Absolute Return 25.0 12.0

CurrentAllocations RecommendedAllocations

CurrentAllocations

RecommendedAllocations

The recommended weightings would produce an expected annual return of 14.42% with volatility of 14.12% and a Share ratio 0.987. The efficient portfolio associated with the choices of the Offices investment options is presented in the chart below.

RiskReturn
16% 15% 14%
Return

13% 12% 11% 10% 7% 8% 9% 10% 11% 12%

Recommended Weightings

13%

14%

15%

16%

Risk

The weightings and their resulting risk-return relationships produce the utility curve for different risk aversions, as provided in the chart below.

UtilityasaFunctionofAllocationofRiskyAssets
0.10 0.10 0.09 0.09 0.08 0.08 0.07 0.07 0.06 0.06 0.05 0.06 0.07 0.08 0.09 0.1 0.11 RiskandRisk Aversion(2 4) 2 3 4

Utility

The underlying assumptions for the different asset classes and proxy indices for those classes were used to calculate their covariances are presented in the table below.
LongTermRiskReturnAssumptionsforEndowment AssetClass USEquities ForeignEquity FixedIncome EquityIncome RealAssets PrivateEquity AbsoluteReturn Risk(%) 9.00 12.20 6.58 9.00 14.30 20.00 12.71 Return(%) 20.00 16.70 4.64 19.48 14.50 29.10 15.74 ProxyIndex Wilshire5000 MSCIEmergingMarkets BarclaysAggregateBondIndex TRowePriceEquityIncomeFund NCREIF CambridgeAssociates 1YearTBill+6%

Caveats The investment allocation recommendations could potentially increase the risk of the endowments portfolio if there is too much duplication in the portfolios of the various public and private equity funds that the Office invests in. Also, market cyclicality periodically affects real assets and the price of gas and oil have become more volatile due to the speculators and futures market, which makes guesses or assumptions about the price of oil or gas in the future. Additionally, the lack of transparency in some emerging markets could be hiding potential time bombs in terms company profits, currency deflation or regime change. There are country risks that have to be managed in the Offices foreign equity and international private equity investments. Increasing international investments may not increase market volatility, but may have other risks, such as asset nationalization, such as occurred in Venezuela. Events like continued conflict in the Middle East are likely to hurt the overall global economy, while providing increased returns for holders of oil and gas assets. So, gains in some asset classes could come at the expense of others. Conclusion Although there are some risks from the investment strategy adopted by the Yale Investments Office, its endowment is by no means unmanageable. Many corporations manage cash and investment accounts much larger than the Offices endowment. As previously mentioned, Fidelity halted contributions to the Magellan fund when they thought that it had gotten too large, but it was five times the size of Yales endowment when that happened. The Office has been a diligent and disciplined investor that has taken calculated, well-researched risks. As the allocation of assets increases in its international component, there will be more risk. But there will also be more reward and more opportunities for the endowments investment advisers to take advantage of market inefficiencies.