Inside Commonfund

One can imagine the dilemma facing the $26 billion Commonfund as the second act of 2010 unfolded. Signs of life in private equity investing were becoming increasingly apparent, as the wave of 2007’s credit crisis finally showed signs of subsidence. Volatility remained, but the market’s pulse, waxing equity prices and renewed M&A activity suggested it was time to start talking seriously to long-term investors about assuming greater portfolio risk.

That was the theme calmly strummed by Commonfund chief executive officer Verne Sedlacek when he appeared as a guest on CNBC’s “Power Lunch” in July, a period in which both markets and investors remained uncertain in their outlook.

“From the standpoint of endowments being long-term investors, you have to be willing to ride through some of the volatility you see in the market,” he told viewers.

Sedlacek had good reason to remain confident. In many ways, it was the old message that the Wilton, Connecticut-based Commonfund first began honing as a non-profit organisation after its formation in 1971 with a grant from the Ford Foundation. Having made its first private equity investment in the 1980s, Commonfund had long been a champion of using alternative investments. Its clients include endowments such as those connected with the universities of Harvard, Yale, Northwetern and Pepperdine.

In fact, about 23 percent of Commonfund’s $26 billion in assets are targeted at private equity, representing $5.98 billion. A further 15 percent of the portfolio is in venture capital: roughly $3.9 billion.

But the tenor of Sedlacek’s pro-risk message would have to be cautious, given the carnage suffered by Commonfund’s core clientele, a cadre of some 1,580 foundations and endowments (also, primarily non-profits) whose overall portfolios tumbled 26 percent for the year ending in mid-2009, bouncing back with a gain of a more modest 12 percent one year later.

On the upside, Commonfund investors remained largely steadfast in their commitments. “The appetite for [alternatives] has remained relatively steady. For 10 years, there was substantial growth in alternatives, up until 2008.  In 2009 and 2010 allocations have remained relatively static; they haven’t increased or decreased,” Sedlacek said.

That may be changing. As the fourth quarter of 2010 rounded, private equity investors could see for themselves a turnaround was underway for private equity in general and in particular for the Commonfund’s roughly $6 billion private equity-focused fund of funds.

“There were four realisations in their fund of funds late in the year valued at $2 billion. That’s an impressive amount. It was part of a wider trend that shows where we are in the investment cycle. It also means more cash for investors to make new commitments,” one investor familiar with the Commonfund told PEI in late December.

The general market rebound and ensuing realisations started to make Commonfund’s private capital fund of funds investments look even better on paper, according to investors.

Though private equity is a long-term investment, underlying investors do keep monthly scorecards. For instance, Commonfund Capital Partners 2000 was up 14.9 percent net of fees for the 12-month period ending 30 November and was up 8.5 percent over the last five years, according to the Berkshire Taconic Foundation. That figure represents an impressive rebound considering returns had been slammed in 2009, a period where the IRR was negative 3.6 percent.

Commonfund Private Equity Partners VII, a fund which closed in 2007, was up 9.1 percent on the year through November, a remarkable reversal given its negative return of 13.5 percent net of fees for the previous three-year period. Commonfund Private Equity Partners VI, a fund that closed in 2006, was up 12.4 percent net of fees for the year ending 31 October. Commonfund Private Equity Partners V, raised in 2005, was up 15.6 percent net of fees over the same period, according to investors.

The Commonfund itself does not comment publicly on the performance of its fund of funds. But in the wake of three difficult years for the entire industry, endowment investors are finding that the less liquid investments like private equity do offer a higher rate of return, according to John Griswold, who heads the Commonfund Institute, the group’s research division.

“Private equity has shown signs of recovery, but there has not been a pick-up in venture capital for the most part. That said, we are not seeing a net change in asset allocations, though the results are preliminary for 2010. I think [2011] will begin as the period of rebalancing, where the worst of the financial crisis is behind us,” Griswold told PEI.

Interestingly, the Commonfund Institute’s research shows that allocations to alternative investment at foundations and endowments hit 36 percent for the fiscal year ending in June 2009, up from 28 percent the previous year. And during fiscal 2009, private equity portfolios at endowments proved relatively resilient with a drop of 7.8 percent, while hedge fund and international equity portfolios fared far worse.

“One consequence of the financial crisis has been a disconnect between risk-taking for longer-term investors. If you take risk, the reward potential may be great as we enter a turnaround. It may turn out that we are facing markets with the greatest return potential that we will see in a lifetime, but you have to have exposure in the asset class. It’s a message that we’ve found resonates with our investors – risk is necessary for investors like endowments. At the most basic level endowments are seeking returns in excess of 5 percent over inflation,” he said.

Separate from its research-oriented Commonfund Institute, Commonfund’s private fund of funds offers venture capital, US private equity and non-US private equity investment programmes.

“Commonfund made its first private equity investment in the 1980s. We run $11 billion in our private capital group, which includes private equity and venture capital. That continues to be an important part of our business as we go forward,” said Keith Luke, Commonfund’s managing director of strategic planning.

Like other private equity groups, the firm has found increased opportunities in emerging markets. Commonfund Capital today maintains a satellite office in Beijing to keep an eye on Chinese and Asian markets, where it remains active. The organisation has been something of a pioneer, making its first investments in China in the late-1990s, when other investors were still chasing late-to-the-party dotcom startups. The firm was also one of the founding members of the Emerging Markets Private Equity Association in 2004. The private investment group today has portfolio investments that span six continents.

Of late the firm’s investment division has tapped opportunities linked to a resurgence in small- and mid-market deals in North America. For instance, one of its most recent allocations went to Prospect Partners III, a $275 million fund that closed in September and targets US companies with revenues of less than $75 million. Commonfund also has current commitments with mid-market buyout specialist Stonebridge Partners, which manages $600 million, as well as Summit Partners, a group that has raised $125 billion in private equity and venture capital since 1984. Summit specialises in providing growth capital and made about 13 new investments in 2010, about half to tech companies.

On the venture side, Commonfund has focused primarily on information technology, life sciences, healthcare and clean technoloy. Allocations have gone to established firms like Kleiner Perkins Caufield & Byers, the storied Silicon Valley venture group that was an early backer of the likes of Amazon.com, Sun Microsystems and Juniper Networks.

Investors say the case of Kleiner Perkins Caufield & Byers makes for an interesting parallel to the Commonfund, in that both were pioneers in alternative investing that relied have relied heavily on the endowment community for commitments.

“The challenge, going forward, for the Commonfund is to reach beyond that endowment market. There is still growth potential with endowments for private equity and venture capital, but it’s reaching a stage of maturity where the growth [in terms of a greater percentage of overall allocations] may slow,” one general partner says.

That said, Commonfund is already looking to grow beyond its historical stronghold of catering to endowment investors. Heading into 2011, the organisation has firmly set its sights on adding corporate and public pension plans and has a target of attracting $500 million or more in assets to its client roster through its Custom Investment Office.

The CIO programme, an investment management outsourcing business, was quietly launched in mid-2010 as markets showed signs of rebounding. The initiative was followed by a wave of new hires and staff changes at the Commonfund. Douglas McNeeley was promoted to head of Commonfund’s New Markets Alternatives Sales Team. Brought onboard as a managing director was Carlton Byrd, who previously worked for US Department of Treasury Office of Financial Stability, where he developed and oversaw asset management for the $700 billion TARP programme. Two hires came from Morgan Stanley’s institutional sales group – Seyonne Kang and Karen Morehouse, both of who joined Commonfund as directors in 2010.

The newcomers join the organisation’s already highly qualified staff, headed by Sedlacek who served as chief financial officer of Harvard Management before joining Commonfund in 1998 as chairman. The chief risk officer remains William Martin, former chief risk officer for Bank of America’s investment division. Other key personnel include chief operating officer Lyndon Tefft (who also previously served at the Harvard Management Company) and Susan Carter, the chief executive officer of Commonfund Capital who also sits on the advisory board of Silver Lake Partners.

Griswold says that with a recovery in sight for private equity, advisory and consulting services like Commonfund’s new CIO programme may play a critical role for both established limited partners at endowments as well as for first-time investors in alternatives at public pension plans.

“One fallout of the financial crisis has been that the investment process has become much more selective. There has also been a shift among limited partners to rely on [investment] committees and trustees and their own officers to make decisions that would be better handled in conjunction with advisors,” Griswold said.

“The research tells us, as well as common sense, that board members and trustees who meet for 10 hours a month aren’t realistically in a position to make long-term investment decisions,” he said. The message from Commonfund is clear: go it alone at your peril.