A year ago, major endowments, like Yale, Harvard, and Princeton were seen as the ne plus ultra of sophisticated private investors, regularly posting 20%+ annual returns. Now they are dumping big chunks of their private equity holdings at distressed prices. What gives?
The reason this is odd is that the last thing you want to sell in a bad market is an illiquid asset. Even in good times, you take a discount for liquidity (dunno what current benchmarks are, but in the stone ages, the discount for valuation purpose for privately placed, unregistered securities was assumed to be 20% to 40%. But the current environment is much more like my childhood in the securities industry, so that might not be a bad starting point.). Consider art. In bad times, top paintings suffer least, but the second tier goes for very little, and a lot simply does not sell. Ditto other collectables and estate jewelry.
So why are so many endowments all running for the hills with private equity now? It was a no-brainer as soon as the leveraged loan markets froze as of last August, leaving investment banks with lots of unsold inventory, that the PE industry was going into a sustained downturn. Investment banks bridging loans is a firm-wrecking strategy and a clear sign of a frothy market (the practice was last seen circa 1989 and eliminated bulge bracket investment bank First Boston as an independent player). The big PE firms has done a monstrous volume of deals in 2006 and valuations were rich. Despite the common perception that a public offering is the exit strategy for PE deals, other PE firms more often than realized will buy operations from another PE firm’s deal, and whole companies are sometimes traded. So an important buyer group is lost, which limits exits and lowers prices in aggregate.
And there are powerful synergies between PE deals and public equity valuations. Again, in the heady 2006-early 2007 period. PE firms were bidding for unprecedentedly large firms. and were sufficiently active so as to provide a boost to general equity valuations. In 1987, in the months before the crash, one major Wall Street firm (for the life of me, I cannot recall which one) attributed 75% of the increase in market averages over the last year to M&A activity. In those days, so-called “financial buyers” aka LBO funds, were more active than strategic buyers.
Funny that no one attempted a similar analysis in 2006. but of course, the sell-side analysts then were more into “sell” and less into “analysis” than their predecessors.
That is a very long winded way of saying that if one were to have taken a jaundiced view of things, M&A bear markets tend to be protracted and nasty, and deal values plunge at those times, If you thought you might need to lighten up, the time was a year ago. Even then you would have taken an ugly haircut, but off a a much better valuation.
But were any of these endowments in 1980s LBO funds? Doubtful. KKR did a great job of cultivating public pension funds, but for the most part, the first generation LBO firms did not attract a lot of institutional money. Remember, they were raiders and did hostile deals. The current version is much more white shoe. So few lived through that period, and even those endowments that had LBO investments back then almost assuredly have no institutional memory.
So with that long preamble, the problem is the stated reasons for selling these private equity positions do not add up,. We will get to my nefarious theories in due course. But let’s start with the background and party line.
From Bloomberg:
A push by the richest U.S. universities to unload their stakes in private-equity funds is flooding the market, driving down prices for the world’s best- known buyout firms.
Investors led by Harvard University, which manages the largest U.S. endowment at $36.9 billion, may increase so-called secondary sales of private-equity funds to more than $100 billion during the next year, overwhelming available pools of capital. Interests in funds managed by KKR & Co., Madison Dearborn LLC and Terra Firma Capital Partners Ltd. all are being offered at discounts of at least 50 percent, according to people familiar with the sales.
Crippled financial firms such as American International Group Inc. and bankrupt Lehman Brothers Holdings Inc. are joining strapped endowments such as the ones at Columbia University in New York and Duke University in Durham, North Carolina, in trying to sell private-equity stakes…
“There’s a huge supply-demand imbalance,” said David De Weese, a general partner at Paul Capital Partners in New York, which manages $6.6 billion. As much as 10 percent of the world’s $1.2 trillion of private-equity interests may change hands next year in the so-called secondary market, up from an average turnover of about 1 percent….
Officials at Harvard are in talks to sell $1.5 billion of limited-partnership holdings in leveraged buyout funds, including one run by Boston-based Bain Capital LLC, according to a person briefed on the situation. Harvard and other endowments have suffered lower returns this year and face further writedowns on their private-equity stakes when the funds report their third- quarter valuations…..
Yves here. Apologies for the detail, but you need to get specific to parse properly.
Ahem, This is a year when every asset class is down (Treasuries are not an asset class) globally, only three stock markets are up (one was Ecuador) and Harvard is yanking out money because “returns are down”? That implies returns are positive. If that was true through end of second quarter, the relative performance was great and they’d be making a mistake to sell given the illiquidity discount.
The only logical explanation is that the investors don’t trust the valuations. Are PE firms carrying investments at book value that really ought to be written down? A quote later in the piece provides indirect confirmation:
Blackstone Group LP, whose $21.7 billion buyout fund is the industry’s largest, wrote down the value of its holdings by about 7.5 percent in the third quarter, the New York-based firm told investors last month when it reported results.
Back again to the story:
“Shares of KKR Private Equity Investors LP, which invests in KKR’s funds and trades on Euronext Amsterdam, lost about 25 percent of their value during the third quarter. Blackstone shares lost about 13 percent of their value during that period….
The endowments want to pare private-equity holdings to free up cash for new investments and to reduce the number of managers they have to monitor
Yves here, If you believe that, I have a bridge I’d like to sell you. Back to the article:
The California Public Employees’ Retirement System, the largest U.S. public pension fund, has sold private-equity partnerships and opted instead to invest in secondary funds. Calpers, based in Sacramento, disclosed last month that it has disposed of $2 billion of private-equity partnerships this year…..
So Calpers got this right, They dumped when times were relatively good, and are now buying back pieces at somewhat lower prices (the same downdraft they would have suffered, more or less, had they stayed as long as they were) at the 50% plus “all sellers, no buyers” discount on offer now. Sweet.
Back to the piece:
Also squeezing limited partners is the so-called denominator effect. With the Standard & Poor’s 500 Index down 39 percent this year, institutional investors’ public equity holdings are suffering. When the value of those holdings (the denominator) is lower, the percentage of the overall pool devoted to private equity (the numerator) rises, pushing the percentage of illiquid asset classes like private equity too high….
This is where mechanically administered portfolio allocation rules wreak havoc. We have entered a highly volatile period. Valuations at any quarter end can reflect a recent, and very short lived burst of optimism or pessimism. Didn’t program trading teach us that defaulting to rules about when and how much to sell wasn’t a great idea in wild markets? For instance:
Sales will be driven next year by institutions such as New York-based Lehman, which filed for bankruptcy in September and had more than $1 billion invested in private-equity funds. AIG, which must repay a $60 billion federal loan, has about $28 billion in alternative assets, including private-equity stakes…
Also helping drive down the price of private-equity assets is a lag in reporting compared with publicly traded companies. Since June, the last quarter for which many of the firms’ values have been calculated, the S&P 500 has dropped almost 30 percent.
Part of the problem is the same storyline is being applied to disparate players (in terms of size and immediate need for cash).
I suspect the reality for some funds is that they need to sell for straightforward operational reasons. Maybe it;s portfolio allocation rules, maybe it’s point of view that equities will rebound sooner (and perhaps may also be paying decent dividends.
But how could these supposedly savvy players not anticipated a PE drought, particularly since they coincide with equity bear markets? It seems the real problem is these supposedly conservative investors took on way too much risk.
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I doubt if anyone read my (insane) post several weeks back on November 8th, 2008:
It was an effort to show how problems in the pre-TARP era had evolved, e.g:
BlackRock, the asset management firm hired to advise Florida on a state pool whose subprime-tainted holdings led to withdrawal of almost half its $27 billion assets, recommended yesterday that the remaining holdings be split into two entities to ensure the fund’s survival.
Hence, many schools will be forced to write off holdings and re-structure many investments. The spin in Florida is very unusual, but is a great example of how creative financial engineering will be used in this on-going mess.
Re: University of North Florida
Board of Trustees
October 2, 2008, 2:30 p.m.
University Center, Room 1058
Agenda
http://www.unf.edu/trustees/botagenda/agenda100208.html
Item 6 Memorandum of Understanding (MOU) between the UNF Board of
Trustees and the UNF Financing Corporation (UNFFC)
(Attachment 1, 2)
See weird comments here: http://www.nakedcapitalism.com/2008/11/fed-stonewalling-on-giving-details.html
Yves, a buddy of mine in the PE group at WF has been telling me for months that a disaster is forming. Many of these deals included large capital commitments by the LPs that have not been called. As Anonymous says above, it appears likely that those capital calls are visible on the horizon. How much do you want to bet that the Harvard Endowment didn’t fully account for this downside?
I don’t see any mention of Yale at all in the linked Bloomberg article. How did they make it into the headline here?
Someone mentioned Yale to me privately, but I do not have independent confirmation and so will remove it from the headline.
Re the capital calls: why would the funds be making capital calls? Generally, those take place when they make new investments. No debt on offer, so not many deals happening.
And the funds would be loath to put more investor equity into existing deals unless they were highly confident that the incremental money would improve returns. Otherwise, it would reduce the published track record. They have incentives not to throw good money after bad.
Yves, my limited understanding on PE problem is:
1) Most PE deals in recent years were constructed with short-term financing to maximize returns.
2) LPs anticipated investments at a ratio of their commitment, typically 50-60% because a portion of the early distributions was typically available to fund later obligations.
3) Traditional maximum net investment level (fund-wide cumulative drawdowns less cumulative distributions) were perhaps 2/3, but more recently as little as 1/2. Fund cash-flow was planned on this basis.
Now the loans are coming due for vintages of a couple years ago, they cannot be refinanced, there is no exit, and the LPs have not exhausted their capital commitments. If I were an LP that would make me nervous…
Zero,
Aha, that makes sense, but using supposed equity capital from investors n place of debt will kill returns and cause lasting damage to the industry. Who’d ever want to take that kind of risk again?
Yves, it’s a good point but as an LP would you rather cough up some more cash or see your fund default? Sounds like some fun meetings with the GP, LPs, and banks.
you have no idea what a s***show this is shaping up to be.
PE portfolios were supposed to be self funding. however, with the equity markets shut, the duration of the existing portfolio has extended dramatically. combine that with the drop in the markets and many institutions are projected to go well over their targeted PE allocation in the coming years as capital calls are made.
at the same time, there is a significant adverse selection risk. i’ve heard that many sponsors are calling capital to buy leveraged loans, to inject equity into existing companies, etc. the limited are nervous that these capital calls are being made in order to guarantee access to the funding before the liquidity environment takes another leg down.
the final issue that many of the endowments are dealing with is the fact that they’ve guaranteed the university a certain dollar amount of funds each year for operating budgets and capital improvement initiatives. those fixed costs are very difficult for an endowment manager to renege on. the smarter universities are doing longer range (3 yrs out) liquidity projections and realizing that they have big problems down the road if they don’t do something about this today.
so far, here’s what the scuttlebutt is on some of the larger endowments:
Duke – epic disaster. supposedly marketing $3B of investments and future capital commitments (note the entire endowment is only $6B). rumors are so rampant that the president of duke sent out a letter to alumni a few weeks ago denying there is a problem. not a good sign.
Harvard – bad, but not nearly as bad as duke. marketing $1.5B of PE on a total base of $40B. not going to mortally wound them. but they are telling PE firms that if they ever want to get money from harvard again, they should not call existing commitments.
Stanford – heard they had to draw on a line of credit to fund the last round of capital commitments. unclear the extent of the liquidity pressures.
MIT – closed for business for the next several years.
one of my contacts on the LP side of the business told me that the universities out shopping PE participations – even today – are the smart ones. they are the ones who realize that they have looming liquidity problems in 2010 and 2011.
the problem is that there are hundreds, if not thousands, of small institutions without the resources to map out the liquidity projections. they are all going to face significant cash crunches in a couple of years as commitments are drawn down in an environment of limited exits.
Yves,
Your blog has become tentative gospel for me as I began following the crisis months ago. I have a somewhat specific question on any knowledge you have on University of Chicago maneuverings regarding their endowment.
Background: I’m a graduate student here. We got an email a month ago outlining how the current economic environment will have an uncertain net impact on the University, but “It is inevitable, however, that we will need to make significant efforts to reduce costs in the near term.” There was also language about the “ambitious” nature of recent growth.
Any clue on relative holdings or strategies, their relationship to post-Friedman theory and strategy? Keep in mind, we have an ongoing issue with graduate student pay and gigantic capital investments (including the controversial $200 million Milton Friedman Institute ).
Here’s a recent article: http://www.chicagobusiness.com/cgi-bin/news.pl?id=31985 It gives some interesting numbers, like 30% hedge fund investment, but the school hasn’t released investment results for the past fiscal year.
Frankly, I’m way over my head with much of the economic practice you discuss, but I consider your insight into historical and social factors immensely useful. In light of that let me just contribute to the overall discourse by saying how fundamentally troubled I was that it took weeks before mainstream commentators were discussing the practical role of trust in market relations.
Great post.
To bond investor: What does “closed for business” @ MIT translate to? (ie, no new biz?)
Yves: And the funds would be loath to put more investor equity into existing deals unless they were highly confident that the incremental money would improve returns. Otherwise, it would reduce the published track record. They have incentives not to throw good money after bad.
FWIW: We saw similar behavior during the tech wreck. The problem is that the incentive of the fund GPs is not completely aligned with the fund’s long-term performance.
Remember the old saying? In ten investments, 3 go north, 3 go south and 4 turn into the living dead. If GPs put a bullet into all of the bad investments, then the 2% (or 3%) carry drops off substantially. That drop-off translates to scaling down your operation. So naturally, they ditch some of the obvious losers but inject more capital into the “living dead”. They mark the valuations of the living-dead and then force layoffs/scaleback at the next board meeting.
Yes the long-term performance suffers, but the short-term GP salaries will suffer less.
Among other pursuits, I have a consulting agreement with a large PE fund of funds whereby I assist them in one particular sector of the market. Anyhow, this firm was shown a piece of a PE fund that Lehman had invested in that was (and still is) for sale (invested in my sector of expertise). My client did not bid on the position. The reason is that only 60% of the partnership’s capital had been called and the valuations the GPs were using for the portfolio companies were absurd. And the remaining 40% to be called was already earmarked for an investment at a price that would be marked down 40% in a publicly-traded market (the partnership had already agreed on the investment and the pricing). So, once you took into account the marks to the existing portfolio, then added in the mark to partnership’s final investment (because the purchaser of Lehman’s position would have to make the final capital call), it didn’t even make sense to bid at all. Stuff like this is happening all over the place.
On a separate but similar note, I find it somewhat amusing that so many so-called hedge funds are now freezing redemptions because they’re now discovering – Quelle Surprise! – that their positions are less liquid than they previously believed. And when the entire elephant herd wants to exit at the same time, folks get trampled. This is a simple problem of asset-liability management run amuck. If you hold illiquid (long-term) assets against the liability that too many investors will want their money today (short-term), you’re no different than a bank under a liquidity squeeze… with similar consequences. Several years ago I raised a small private equity fund. I could have raised three times as much money as I did had I used a hedge fund format (that is, offering regular liquidity withdrawals), but in the back of my mind I thought, “I don’t trust these folks – they’ll panic and flee if I don’t lock them down.” So I took the smaller amount and locked them in for 8 years (plus 2 one-year extensions, if necessary). That’s the smartest business decision I’ve made in the last several years. But I find it irritating that, as it turns out, many “hedge funds” aren’t altogether different from my private equity fund – they just marketed liquidity and cut it off when it suited them. So they turn out to be private equity in drag. And I see this and feel like I’m the dumb one for being honest from the get go. Anyhow, we’ll see how it all turns out – but it ain’t looking too good.
And I see this and feel like I’m the dumb one for being honest from the get go.
Probably not. Just remember: What goes around, comes around.
Ignoring the Treasury bubble, the cost of capital has soared. The debt bubble allowed the pirates to spend money they don’t have (the Wrongald Reagan gambit for printing money).
I suspect the PE firms are leveraged to the hilt, just like every other financial operation being operated by the geniuses brewed up by our so called institutions of higher learning in the last 15 years.
Why wouldn’t the simple explanation be that investors are panicing to get out as asset values return(crash) to earth. Maybe the best thing is for the Harvard endowment to become 10B instead of 36.7B.
PE was just a variation of the buy and flip strategy, camouflaged by having a management team of supposedly very bright people who knew what they were doing. PE marked where they wanted, Harvard Endowment managers accepted the cheery marks (their bonuses probably depeneded on it), and the whole Ponzi scheme continued right on its way until somebody wanted their money back.
Great posts by several of you, particularly bondinvestor. In the last several years, David Swenson’s (investment guru at Yale) philosophies about the implied liquidity premiums attached to the stock and bond markets and how “permanent endowments” don’t need much liquidity have really taken hold.
So, the rush has been on to add illiquid “alternative” investments at major and minor endowments.
Whenever anyone would question the possible need for cash for capital calls, they’d be told “don’t worry, you can use the cash flows that you’ll be receiving from our earlier deals to meet the new capital calls”. Obviously, there aren’t many cashouts going on these days and it doesn’t look like there will be for a while.
But it gets worse, most of these large endowments have “spending policies” which call for something like “five percent of the trailing twelve quarter average endowment balance”. This had been done to smooth out volatile years. But now, with many values down 40%, this equates to something like 7% of what’s left. There was an article in the NY Times last week which indicated that U VA had only 21% of their assets liquid. So, if they need to spend ~7% out, and have a bunch of capital calls pending, they could also be at risk. Incidentally, the former head of their investment company went out on her own a couple of years ago and set up a company to many funds for smaller colleges and universities. I wonder if they’ve got similar problems?
It will be interesting to read the impending second edition of David Swensen’s “Pioneering Portfolio Management: An Unconventional Approach to Investment”. From the front flap of the original “Swensen’s book is an indispensable roadmap for creating a successful investment program for every institutional fund manager”.
Swensen is Yale’s Chief Investment Officer. The first version of the book was published in 2000. This version was originally slated for released in Oct, but has been pushed back to Jan.
does anyone else see a disturbing correlation between these enormous endowments (and the types of ‘assets’ they invested in) and the astronomical cost of attending university?
does anyone else see a disturbing correlation between these enormous endowments (and the types of ‘assets’ they invested in) and the astronomical cost of attending university?
I work in academia. The only alternative is the football program. You pick.
The two choices are that dumping your least liquid stuff in a brutal bear market is a bad idea.
Verses the idea that dumping the least liquid assets in a brutal bear market is a great idea.
The only obvious thing is that the valuations of PE are very optimistic.
Also, I have a feeling that the smaller guys will do worse then the larger ones. The exception being the real Luddite foundations and pension funds that just bought stocks and bonds.
One other perspective is that the large private university endowments are probably closer to $200 billion and declining. Yea, it is a big chunk of alternative investments, PE, etc. CALPERS used to be over $200B.
I would hate to be one of the big schools begging for more money these days. HYP can coast forever on their reps, but a school trying to claw its way up the UNWR rankings by emulating the big dogs are going to see some major damage.
I’m in the PE business and I note the comments re: the fund manager’s economic disincentive to commit incremental LP dollars in support of a stalled/weakening investment and posit an alternative motivation which has dominated the PE landscape over the past 3 years – the acceleration of investment and successor fund raising cycles and the resulting shift in GP economics from long-term wealth building through carried interest to near-term wealth building from increased management fees.
Don’t lose sight of the GP’s motivation to increase assets under management (paying a 1.5% – 2% management fee), the benefits of which are typically enjoyed by a static group of individuals. As such, it is not inconceivable that a GP may commit fund capital to support an underperforming investment to avoid taking a write down during a fundraising effort.
Harvard President Drew Faust posted a document on her web page yesterday saying that, “we are planning to issue a substantial amount of new taxable fixed-rate debt.” (http://www.president.harvard.edu/speeches/faust/081202_economy.html)
She claims it is to cover operating expenses, but given the comments here it seems likely that there is more to it than just that.