Yale Pays for Access

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Yale recently defended its payment of high investment fees at time when other larger investors are using low cost, passive equity strategies. While Yale’s use of illiquid assets is partly the reason for the high fees, the debate really illustrates the rise of the private over public equity markets.

Despite having $26 billion in assets, Yale said in its latest annual report that it could not negotiate lower fees because…

“Venture capital and leveraged buyouts present the greatest challenge, as the overwhelming demand for high-quality managers reduces the ability of limited partners to influence deal terms”

Said another way, the demand for talent (managers) exceeds the supply of money (investors). Some have argued the demand for venture capital and leverage buyout investments is driven by performance which has surpassed that of hedge funds since the 2007-2008 financial crisis.

Andrew Lo of MIT said:

“Fee negotiations really depend on the leverage that the parties have. Hedge fund managers have not been producing tremendously attractive returns, they are not going to have much leverage to negotiate better fees….

On the other hand, very successful venture capital companies and private equity companies have produced very attractive returns, and will have much more negotiating power.”

The demise of hedge funds signals the decline of public equity markets. With the rise of information, technology, and hedge funds, public equity markets have become so liquid that there is little chance for most to outperform the market.

Kenneth Griffin of Citadel reflected this week on the state of the hedge fund industry…

“It’s harder to create alpha today, there’s more competition, there’s a lot of very sharp people trying to find opportunities in the market place. This is causing some of the second-tier players to fall by the wayside.”

Unlike public markets, it is difficult for most to access the illiquid, private markets. Rather than paying for performance, Yale could be paying high fees simply to access the deal flow of venture capital and leverage-buyout firms.

 

Yale’s Excellent Venture Capital Returns

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For the past ten years, Yale has earned an annualized return of 16% on its venture investments. The fair value of the venture investments is now $4.3 billion, which represents 16.2% of the $26 billion Yale Endowment. The results were included in annual financial statements for the university dated October 31, 2016.

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Source: Yale’s FY 16 Financial Statements

The Yale Endowment began moving away from traditional stocks and bonds to alternative assets, such as venture capital, after David Swensen took over as CIO in the early 1980s. For the past six years, venture investments, as percentage of the total endowment, grew from 10.3% in 2011 to 16.2% in 2016. For the past three years, the venture investments’ fair value has risen from $3.5 billion in FY 2014 to $4.3 billion in FY 2016.

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Source: Yale Endowment’s FY 15 Report and Yale’s FY 16 Financial Statements

More than the size of its investments, Yale Endowment’s commitment to venture capital is probable most important.  As an endowment, Yale is the ultimately long-term investor, who can wait to see the returns from venture investments; this is unlike recent venture investors such corporations, hedge funds, and mutual funds who may have shorter time horizons.

As an early investor in venture capital among university endowments, Yale was one of the first to established relationships with top tier venture capital firms. These ties have allowed Yale to be successful with its venture investments while other endowments have struggled. For example, Harvard’s endowment also announced FY 2016 results, including those for its venture investments. Harvard’s annualized return for the past five years was 6.2% and negative 1.5% for FY 2016.

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Source: Harvard’s FY 16 Financial Statements

Harvard Defeated by Unicorns

Venture capitalists shouldn’t be blamed for Harvard’s loss to Yale and Princeton. No this isn’t football, but it’s the season of the year when Ivy League Endowments release their annual returns and Harvard hasn’t been beating the second and third largest endowments. Harvard loses – as seen below – because it hasn’t fully participated in the rise of the unicorns.

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Source University Reports

Back in the early 1980s, Yale Endowment’s David Swensen began investing in private equity assets, such as venture capital and leveraged buyouts, and away from traditional stocks and bonds. Over the years, David Swensen taught others the “Yale Model”, including Andrew Golden who now manages the Princeton Endowment.  As seen in the graph below, private equity makes up more of the endowments’ of Yale and Princeton, than Harvard.

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Source University Reports

Private equity allocations can grow from additional investments, but also from unrealized gains especially in venture capital assets. Princeton in FY 2015 reportedstrong performance within our venture capital portfolio (that) further boosted” returns of its private equity assets to 21.8%. Yale devoted its FY 2015 annual report to its venture capital investments which had a twenty year weighted return of 32.3%.

Harvard has also benefited from venture capital. For FY 2015, Harvard reported increased returns in private equity were due in part to “the strong performance of 29.6% produced by our venture capital investments.” But Harvard loses because the endowments of Princeton and Yale include more private equity assets and thus have benefited from the recent rise of unicorn valuations.

Unicorns and endowments returns are somewhat works of fiction. Endowments returns are based on limited partner financial statements provided by the venture capital firms. These firms use different methods to value portfolio companies since public market prices don’t exist. So the valuations and hence endowment returns are more estimation, than reality.

Unicorn valuations may also be fantasy. For FY 2015, Harvard Endowment’s former investment manager, Steve Blyth, wrote that:

Venture capital continues to receive ample funding, and private company valuations are also bolstered by public mutual funds entering late stage funding rounds in significant size. This environment is likely to result in lower future returns than in the recent past.

Harvard, Yale, and Princeton have yet to fully report on their endowment for FY 2016. But in the long run, Harvard may still win if unicorn prices don’t materialize along with the paper gains of venture capital portfolios.

 

Spilling the Beans on the Yale Endowment

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The Yale Endowment had spectacular year in venture capital; in fact many decades worth of happy returns. The 2015 annual report is dedicated to…

“Yale’s successful entrepreneurs, technologists, and investors, who strive to transform markets, develop new products and processes, and change the world”.

But why dedicated a whole report to a subset of an asset class (private equity) to trumpet the Yale Endowment’s grand returns?

Get Lucky.  Since taking over Yale endowment in the early 1980s, David Swensen shifted the endowment away from traditional stocks and bonds towards illiquid securities found in private markets.  Higher returns can be found in private markets since the market is not efficiency: there is a lack of information. This in part lead to the spectacular returns.

Another contributing to Yale’s success is timing or just luck. David Swensen’s change in portfolio allocation paralleled the boom in tech beginning in early 1980s. And given the endowment’s long-term perspective, the fund benefit from internet bubble of the 1990s.

Social Network. Yale’s alumni network also contributed the endowment stellar performance. Of the many Yale alums profiled in annual report, two are pioneers: Leonard Baker and William Draper III.

Mr. Draper besides founding Sutter Hill Partners in 1964 is responsible for Tim Draper of DJF. Tim Draper is also responsible for Valley Girl, Jessie Draper. Leonard Baker became a Sutter partner in 1973. Besides sitting on many boards, Mr. Baker belongs to GIC, Singapore’s Sovereign Wealth Fund.

It’s alumni connections which bring investment ideas and opportunities to Yale.  Yale’s investment office also produces which goes onto to work in venture capital. Profiled in the annual report was Nick Shalek who graduated from Yale in 2005 and when to establish Ribbit Capital. In addition, the current head of Stanford’s endowment, Robert F. Wallace, also work at Yale’s investment office and graduated from Yale.

Spilling the Beans. After two decades, why now is Yale reporting its success in venture capital? The secrets of Yale’s success are well known after the publication of David Swensen’s Pioneering Portfolio Management.

Given the outcry over high college tuition and tax-exempt status of university endowments, the Yale 2015 annual report is more marketing than investing. Yale wants to appear to be doing good, rather than just making lots and lots of tax-free money.