YALE ENVY

Many global movements found their genesis in a powerful document – the Old Testament, the Communist Manifesto, The Fountainhead, et al.

The current wave of new and increased allocations to private equity – a trend that is profoundly changing the asset class' landscape – may have as its genesis p. 23 of the Yale University Financial Report 2004 – 2005. This is the document that makes every portfolio manager envious of David Swensen's private equity programme and vow, “I'll have what he's having.”

The page presents a stirring snapshot of an endowment, led by chief investment officer Swensen, that has raced ahead of its peers. It shows Yale's target allocation to private equity as 17 percent, and right below that is a bar chart showing Yale's ten-year private equity returns, net of fees, as being roughly 40 percent. The accompanying report reads: “Alternative assets, by their nature, tend to be less efficiently priced than traditional marketable securities, providing an opportunity to exploit market inefficiencies through active management.”

Now every portfolio manager wants to double down on private equity and enter the promised land of inefficiency, which is of course having the effect of bringing great efficiency to the alternative investment market. A 2006 Commonfund Benchmarks study found that most endowments and foundations have increased their allocations to alternative investments, including private equity. Quoted in a recent article in University Business, Michael West, the treasurer for finance and administration at Skidmore College, says he “believes it is likely that smaller to mid-sized schools like his will follow successful strategies used by the larger schools”.

Now giant pension funds are getting serious about increasing allocations, seriously moving the proverbial needle. A recent example is the California State Teachers' Retirement Board deciding to increase its allocation to alternative investments (hedge funds and private equity) to 9 percent from 6 percent. These allocation increases are being sold to pension board members as “maximizing performance potential compared with mainstream asset classes, while reducing risk”, according to a report released last month by consulting firm Watson Wyatt.

Hedge funds are viewed more as tools to quell volatility, but private equity is clearly viewed as the secret sauce for juicing returns. Pension funds in particular have a great need to boost returns, with funding shortfalls looming.

Gazing with lust upon the Yale data, it's easy to forget that this isn't a benchmark for private equity performance. It is the successful track record of a veteran private equity LP managed by someone who is regarded as a CFA rock star. And yet, just as every child in Lake Wobegon is above average, every portfolio manager seems to assume that he or she will gain access to top-tier GPs and replicate Yale's performance.

A private equity investment officer at a large endowment says he has noted with skepticism the rush of his peers into private equity, and confirms that the Yale track record is often referred to as a justification for going large in the asset class. “For those entering private equity, I've not really heard reasonable arguments as to why a new entrant will capture returns on the high end of the spectrum. The average returns in private equity don't justify getting excited about the asset class.”

(The endowment manager concedes that even a modest projection for private equity compares well against the current projections for US domestic stocks. “If one were to believe that the S&P 500 was going to deliver 9 percent, which is aggressive, institutions will want to get into private equity if they feel they can get 10 percent. That's the mindset that's developing.”)

Yale has been investing in venture capital and private equity for 20 years. It has had access to managers who actually did reap large rewards in an inefficient market, and it continues to have access to the limited number of GPs with long, consistently good track records. New entrants do not. HIG Capital, for example, recently closed a new $750 million buyout fund without allowing in a single dollar from a new LP. An exclusivity that began in the venture world is spreading to the buyout world.

With top managers shut to new money, but new allocations being created by the billions, the result will be a proliferation of new services and investment pools, all of which will claim access to the top quartile. As is private equity's nature, it will take years for people to figure out that some folks have to be in the bottom three quartiles for the top one to exist.