Private equity (inclusive of buyouts, growth equity, and venture capital) remains a compelling long-term asset class, but recent periods of muted distributions and below-average returns have created a dilemma for investors: how should future private equity commitments be sized?
Please welcome the Commonfund OCIO Managing Director, Felipe Arguello and Commonfund OCIO director Rachel Stabola Clivaz. Thank you. My name is Felipe Arguello. I am here with my colleague Rachel Clivaz. We're both investment officers in the Commonfund OCIO team. Thank you all very much for coming today. And don't worry, this is the last session in the last day of the conference. But thank you all very much for coming. We hope that you have enjoyed the content at forum. And I think by now, it's it's fair to assume that we all have skipped something in the last couple of days. Perhaps skip a meal, skip a workout. I'm not going to ask the audience to raise their hand if they have skipped the the workout. Skip a session or two. I'm not asking the audience that either. But what we're here to to talk about today is the risk of skipping something else. The risk of skipping a vintage in your private equity allocation and the gap this can create in your both portfolio construction process and your ability to meet the long term investment objective of your endowment. So to start, we thought of framing the conversation by highlighting some of the hard questions we've been hearing from some of our clients around this topic. A lot of questions about relative return performance. Will private equity ever outperform public markets again? Others asking about the role of private equity within their strategic asset allocation. Should we continue to have private equity as an asset class, the strategic asset allocation? Many concern around liquidity, especially on the higher ed space. Should we lock up the liquidity given all the circumstances that these institutions are are are going through? Others asking about timing, is now the good time to be investing in private equity? And it all comes together with this last question, should we pause new commitments and skip a vintage? So we're going to throughout the presentation, try to answer each one of these questions and we're going to focus on the very last one most of the time. But let me first hit on that very first one around relative return. So here we graph the performance of private equity over the last three years. The median private equity fund has delivered a return of twenty one percent over the last three years since twenty twenty two. If you analyze that number, that is around five point seven percent. I would say that that return is quite mediocre for an asset class such as private equity and not something we would expect from from private equity and that is even more evident when you compare that return with what public equities have delivered over the same period of time, seventy four percent. Look at that gap, it's fifty percent of outperformance of public equity over privates. So the opportunity cost for those that have invested in private equity over public markets has been quite high and that is one one of the key reasons why we're hearing from so many clients around why bother? Why bother investing in private equity when I can get so much better returns on private on on public markets? But here's the critical thing. When you are doing this type of analysis, you cannot base any definitive conclusion just on three years of data. We always encourage our clients to look at the long term and that is especially more important when you're managing long term investment pools such as endowment portfolios. So when you zoom out, what we show here is the three year annualized returns of the MSCI ACWI index going back thirty five years. I think this this is a very interesting graph. This is the distribution of returns of the of the index over that time period. On average, the index has delivered a return of seven point five percent. Guess where we are right now over the last three years? All the way to the right. Twenty almost twenty one percent. That is a significant outperformance versus the historical average. It sits on the ninety eight percentile of returns. So the point here is that, if you are going to compare the returns of your private equity allocation over public markets over the last three years, you need to put into context that the returns that you have been getting from public markets are outside the norm and not something we would expect to continue going forward. So let's go back to one of the questions that we started this session with today and that's about the role of private equity in a strategic policy allocation. Does private equity belong in your portfolio? And here at Commonfund, we would say absolutely yes. And there's really two core reasons as to why that is. Number one is around the return. Number two is what private equity brings from a diversification standpoint as well. So starting with return, I'm going to once again take that long term view. We just talked about that thirty five year time period, but we were looking at just public equities. Let's layer in private equity as well. If you look at this chart, anytime the area chart is above the line, that is a three year period in which private equity outperformed public equities. And very clearly, you can see right away, most of the time private equity is outperforming public equities. Actually, ninety percent of the time that is the case. And that magnitude of outperformance is quite high, on average anywhere from four to six percent. So what does this mean in terms of total return? We just looked at the total return of public equities and private equity over the last few years. What does it look like over a twenty year period, a longer term period? As you can see here, private equity, given the dynamics that you just saw on the left hand side, has produced a total return over twenty years that is far above public equities, actually four times the amount there. So from a return perspective, in just a few moments, we're going to talk about the return objective of nonprofit institutions, how hard it is to reach that overall return objective, we think private equity is very integral in order to achieve those return objectives. From a diversification standpoint, I'm sure it's been in the news, we talk about it all the time in almost every committee meeting, the public equity rally that we've experienced over the last few years has been extremely concentrated. It's really just a few mega cap names driving a huge portion of that performance, and you can see it here especially in US markets. The S and P five hundred now very concentrated, almost forty percent in just ten companies. When you think about trying to make sure that you have that equity risk in your portfolio, but not in such a concentrated way, private equity having an allocation to private equity is a great way to do that. A very diversified approach to public equities, yet still getting that growth, still getting that equity risk. And you can see here in terms of opportunity set or investments available, public equities and the number of public companies available for investment has actually come down over the last few years, while private equity investments have increased. So your opportunity set has widened, and also not necessarily captured on this slide, the way in which private equity managers drive returns for investors is very differentiated, very diversified compared to investing in public equity. So for those two reasons, the return potential available in private equities and the diversification it provides for your equity book, we think private equity is essential for long term portfolios. So after spending three days with us here at Forum, hopefully, we have been able to convince you all that the role of private markets in an invest in the pro role of private investments in an endowment portfolio is very important. And our philosophy for investing in private markets is centered on three key pillars. Number one, meaningful allocation in the strategic policy. If you're going to allocate anything below fifteen percent of your assets into private markets, don't bother. It's not going to move the needle. You need a much higher allocation to private private strategies to give you a better chance of achieving intergenerational equity and meeting your long term returns. The second principle is manager selection and how important it is in private markets. Especially now with the proliferation of private strategies, you need to get access to those top quartile managers to give you a better chance of extracting the liquidity premium from the markets. And finally, discipline, commitment pacing, avoiding the temptation of timing the markets and creating this gap in your portfolio that is going to impact your ability of meeting your long term returns. So through the rest of the presentation, we're going to hit on each one of these three principles and we're going to spend most of the time on this last one around discipline, commitment, pacing. So let me start with the first one, meaningful allocation in the strategic policy. So before we delve into empirical analysis, we wanted to ground our conversation on fundamental principles. James Tobin described the role of trustees as being the guardians of the future against claims of the present. The main responsibility of trustees is ensuring that they achieve intergenerational equity in their portfolios. And this is this this intergenerational equity principle is the lens through which they should evaluate the decision to skip a vintage or not. Because when you're deciding to skip a vintage, it's not just a tactical decision, it's a strategic choice that you are making that was going to have a long term impact on both your portfolio construction process and your ability to meet long term investment returns. So let's highlight how difficult it is to achieve intergenerational equity by a hypothetical example. And we look at here at the just one year horizon. We start with an endowment of a hundred million dollars, inflation erodes two point five percent, we assume the endowment spends at five percent. So you need to generate a return of seven point five percent just to get back to neutral in real terms on your a hundred million dollar starting value. That's pretty straightforward on the one year horizon. We all know we're not managing endowments for one year. The situation becomes a little bit more complex when you expand that horizon. So we look at twenty years. Again, you start with one hundred million dollars inflation, you lose almost two thirds of that initial value on purchasing power because of the effects of inflation. You're spending at seven per at five percent, if you compound that over thirty years, that's almost a hundred and thirty one percent. So just to get back to neutral, you need to generate returns of almost two hundred percent over twenty years. That's not to improve, that's not to get better, that's just to get back to your one hundred million dollars and achieve intergenerational equity. So this is just a hypothetical example. Now let's look at some some real numbers. And we leverage data from the NACUBO Commonfund study of endowments where we gather information from over six hundred and fifty university endowments across the country. We start again with the return objective of seven point five percent. We're looking here at twenty year returns of those endowments that have information. On average, from the NACUBA study, institutions generated six point nine percent return over the last twenty years. They fail to achieve that seven point five percent intergenerational equity. But what we were more curious about is trying to find out how is the effect of an allocation to private strategies affecting that that number. So we divided the data and we look first at the institutions that have zero percent exposure to private assets. It generated six point seven percent of returns. Now we went and look at those institutions that have between zero and fifteen percent of exposure to private assets. Six point seven percent. Sit with that number for a moment. The same return for those that had no exposure to private assets versus those that had between zero to fifteen percent. So it goes back to our initial point. You need a meaningful allocation in your strategic asset allocation to be able to generate additional returns. And yes, there are other factors that may be affecting these numbers, but there this is a key one. And then we look at those institutions that have more than thirty percent exposure to private assets. You see the returns there, seven point eight percent. We're able to get to that magical seven point five percent, preserve intergenerational equity in their endowments and grow the portfolio a little bit more as well. So Felipe just went through why there is a necessity to have a meaningful allocation to private investments in an endowment portfolio. However, once again, let's bring it back to one of our questions that we started this session with around locking up the liquidity. Do you have the ability to take on that meaningful allocation? And this is something that we spend a lot of time working on with the institutions that we partner with, focusing on the ability to lock up a large portion of your investment portfolio in illiquid investments. So there's a few metrics and a few models that are very, very important. Liquidity is not exactly the most exciting topic, so what we try to do is spice this up a little bit with some really fun animations. I can't take credit. It was the marketing team, but we want to look at the net liquidity need on an annual basis for a nonprofit institution. So first, we have to look at the liquidity sources or the inflows of liquidity into the portfolio. You have your external liquidity source, which for some institutions would be endowment gifts coming into the portfolio. That's gonna provide liquidity on an annual basis. And then you have private investment distributions, also a liquidity source. So that is the realized gains coming off of your private portfolio flowing back into your marketable portfolio. So those are your liquidity sources. But you can't look at that in isolation. You then have to think about what are the uses of liquidity? What are the pulls on my liquidity? The largest usually being spend, your annual spend getting taken out of the portfolio, that's a pull on your liquidity, and then you have private investment capital calls. So the money that is sourcing your private investment, private investment opportunities coming out of the marketable portfolio, that is a use of liquidity or a pull on liquidity. The formula becomes quite simple when you want to look at net liquidity need. It's your sources minus your uses. That's going to give you your annual net liquidity need. But once again, that metric in isolation, not very informative. You have to think about how much liquidity is available in your portfolio to meet that annual net liquidity need. So if you take the liquidity available in your portfolio and you divide your annual net liquidity need, what you get is your annual liquidity coverage ratio. Another way to think about that is how many years of my net liquidity need do I have available in liquidity in my portfolio at any given time? So we take a look at that metric, that coverage ratio, in a normal environment, our base case. Okay, if we lock up thirty percent of the portfolio in illiquid investments, what does my liquidity coverage ratio look like year over year in my base case, my base case assumptions? Almost more important though is to stress this as well. So we do a market stress with the clients that we partner with. We not only hit the portfolio from a return perspective, assume that the portfolio falls, but we also stress the portfolio from a liquidity perspective. And we say, okay, what if we enter into an environment similar to what we saw in twenty twenty two, twenty twenty three, and private investment distributions start to dry up? What does that do to the portfolio if that happens at the same time as a decline in markets? And then we make sure we get very institution specific with this model, and we layer in operational stress. What happens if during this market stress, the institution also needs more out of their endowment? It's not going to just be the normal spend of five percent or five and a half percent. What if there is a budget deficit and you have multiple years in which you need to actually pull a special appropriation out of your endowment? Is there sufficient liquidity to meet that need? What does your liquidity coverage ratio look like? So as a reminder, available liquidity divided by annual net liquidity need, that's your liquidity coverage ratio. So we have a hypothetical example of what this looks like for an institution that has a thirty percent illiquid target. So in general, we advise that at the very, very minimum, a liquidity coverage ratio should probably never fall below 3x. Once again, though, this is very institution specific, could be higher than 3x, But at the very base case, the very minimum, you want to at least have three times or three years worth of your liquidity need available in liquid investments. In a normal scenario for a thirty percent illiquid target, that liquidity coverage ratio might hover around eight to nine x. So very, very healthy margin there. If we layer in a market stress where the portfolio is down thirty percent, private investment distributions completely dry up, You can see here it falls. It's no longer at that eight to nine x, but still very much a healthy margin between that minimum threshold. Operational stress gets a little bit closer to the three x, but once again, not hitting that minimum threshold. We see this in a lot of cases. Many institutions that we partner with, they ask that question, can I lock up my portfolio in illiquid investments? Can I really take on a thirty percent target to illiquids? And we run these types of models, and time and time again, we reach the conclusion that most institutions do have a rather large ability to take on a meaningful allocation to illiquid investments. The second principle that we outline is the importance of manager selection. And manager selection is important in any asset class where you decide to take an active approach, but as you'll see on some of the data we we're gonna present, it is even more important when you're dealing with private strategies. So the first chart we want to show you here is the proliferation of private funds being raised. So what we show here is the number of private equity funds being raised annually going back to two thousand and eight. And if you split this data and look at the first ten years, so from two thousand and eight to twenty eighteen, on average, you had around six hundred and fifty funds being raised every year. Since twenty eighteen to two thousand and twenty four, that number has doubled. Yes, there was a spike in twenty one, twenty two, it has come down a little bit, but still significantly above what we had experienced in year past. So the point here is that it is increasingly more difficult for investors, for LPs to navigate through the noise and really being able to identify those top performing managers. And that is actually very important if you look at this data. So here what we show is the twenty year returns of US public equity funds and US private equity funds and we look at the dispersion of returns based on quartile returns. So if you just focus first on the public equity side, the difference between the upper quartile fund and the lower quartile fund is around two hundred basis points. So if you miss your mark on public equities, you are losing around two percent versus what you could have achieved. It is painful. But look what happen if you lose the mark on private equity. Look at the lower performing funds on US private equity, two point four percent. And even more, if you look at the median return, ten point four percent, you kinda like are better off just investing in publics. So again, it highlights the importance of really being able exposure to those top quartile managers where you are investing in private assets. So what could this dispersion mean for a portfolio? If we took a look at the last twenty vintage years and you made equal commitments every year to the median performing private equity fund, the resulting net multiple would be just shy of one point seven x. If you were managing to invest with the top quartile funds across same vintage years, that net multiple jumps to two point three x. So over that twenty year period, that is an increase of point six x in terms of net multiple return. From a dollar perspective, if those commitments that you made over this time period were a million each to growth and buyout and to venture, you're looking at a increase of twenty six million dollars over that twenty year period. And let's bring that back the intergenerational equity conversation. That is a meaningful amount of capital going towards supporting your mission. So just being able to invest with those top quartile managers makes a huge difference in terms of the return you can provide for your portfolio. And I want you to remember the zero point six x and the twenty six million because we're gonna touch on those numbers again in just a few moments. So after twenty minutes of presentation, we're finally getting to the crux of it. Disciplined commitment pacing, the importance of maintaining vintage year diversification in your private equity allocation. And there are many reasons why institutions may decide to consider skipping a vintage. Again, concerns around liquidity, others concern around the cost. It is ultimately a more expensive asset class to access. Complexity around managing the cash flows with distributions and commitments. Definitely some disappointment with recent returns. And then there are others that are trying to time the market. We think that last one is actually the most dangerous one because we know that time in the markets is actually quite challenging. And to illustrate that, we just look first at public equity markets. Timing public markets is also very difficult. Here we show the performance of the S and P five hundred going back to two thousand and we stopped this timeline in at the end of twenty twenty. At that time, equities had rally over fifty percent from the pandemic lows. The S and P closed at all time highs and valuations were quite stretched. Actually, the highest valuations since the dot com bubble. So at that point, any investor could have thought, you know what, it's time to stop, take some chips off the table, I'm going to go underweight equities. But we all know what has happened since then. Market continue to rally up ninety six percent. So the point here is that it is very difficult to time public markets. It's actually more difficult to time private markets and there are key reasons for that. The first one is the liquidity constraint. You have this commitment and deployment gap. When you're investing in private equity, you're not deploying your capital immediately. It can take anywhere between three to five years as deals get closed and source to get that capital invested. So if you're thinking of timing your entry point based on the macroeconomic and market conditions that you're reading today, the problem is that that money is not getting invested today. It's going to be invested in three or five years. And by the way, you're also timing your exit, which is not happening until six to ten years. So who can really accurately predict such a ten year dynamic investment period? And that all gets compounded with the delayed price discovery. So the lag of private company evaluation makes it very difficult to react to market conditions. So and the the last one, the last point I think it is also very important perhaps not so much economic, but definitely makes an important impact on your private equity portfolio which is, if you decide to skip a vintage, actually you are going to be, it's going to be very difficult for you to access those top performing managers afterwards. Some some of those are resource constrained, are capacity constrained. So if you decide to skip a vintage today and you want to go back tomorrow, most likely you're not going to be able. So the point here is that when you're thinking about private strategies, time in the market is much more important than time in the market. But what if you're the smartest person in the room? What if you're the smartest person at Forum, you get every single one of these questions correct and you manage to skip the three worst vintage years over that same twenty year period that we just talked about. You knew exactly when to time the market, you completely avoided the three worst vintage years. So remember, the twenty years that you were investing with median performing funds, you produced a one point six eight x net multiple. Skipping those three worst vintages, congratulations. You got point zero six x. Remember, median fund versus top quartile fund, that was zero point six x of an increase. Timing it correctly and getting everything right, you get zero point zero six x. That twenty six million in extra value that you got from investing with top quartile managers, it's barely two million more if you time everything correctly. And first of all, we just went through why we don't think many people can time everything correctly. And importantly, there are real disadvantages to skipping vintage years. First is around portfolio construction. Second of which is around returns. We talked about the commitment deployment gap. You can't just decide to have a thirty percent allocation to private investments. In day one, you're fully invested, it takes a long time to get there. So this model shows what that might look like. A thirty percent target to private equity, it may take around seven to eight years with consistent commitments across these vintage years. That allocation takes six to seven years to get to that target. Let's say halfway along that journey, you decide to skip two vintages. This results in a persistent underweight to your target. It's very hard to try to close that gap once you've skipped vintage years. And you can see here, actually, this results in a roughly five percent underweight for ten years, just skipping those two vintages. But what if you're already at your target? What if you've allocated for the six to seven years, you're at thirty percent, and then you decide to skip two vintages? You can see that comes down real quick, that allocation, and it stays below that thirty percent target. Once again, you have that gap. It's about a three to four percent underweight that remains for those five years. And why is this so important? That brings us to the return consideration. The opportunity cost of having that underweight to private equity. So if you think about where are you holding that allocation when you're underweight that private equity target, likely you're holding it in public equities. So we look at a very, very important metric here. It's called direct alpha. Essentially what it is, is the return that the private equity managers are producing on an annualized basis above and beyond public markets. And we're focusing on the top quartile managers there because we just went through why it's so important to invest with the top managers. And then what we're doing is mapping that twenty year vintage year cycle. And you can see here in these vintage years, the bottom quartile vintage year, so one of the worst vintage years, you still, with those top quartile managers, are getting a six percent return premium above and beyond public markets. So every year that you are underweight that private equity allocation, holding it in public equities, you're missing out on that annualized return above and beyond public markets. So think about that. The worst vintage years, those top managers are still outperforming public markets. So in the last few minutes here, we want to bring this all home. We're going to do a case study. We have institution A and institution B. Both of these institutions have sat through our session, listened to what we had to say, and they decided, You know what? They're onto something. I think we need to have a thirty percent target to private equity in our portfolio. They ran the stress test. They know they have the ability to do so. So both institutions allocate thirty percent of their portfolio from a strategic policy perspective to private equity. They also prioritize their manager due diligence process. They really focus on manager selection, and they manage throughout the last twenty years to solely invest with first and second quartile managers. Actually, these two institutions are investing in the exact same managers over that cycle. Where it starts to differ is that third pillar. Institution b didn't want to stick with us all the way to the end of the session. They actually left. They decided that they didn't want to listen to us, and they they actually ended up skipping a vintage. And they did that right after the great financial crisis, which was actually a time period where many investors pulled back from private investments because of market concerns. So remember, these two institutions, they are very, very similar. They're both a hundred million. They spend five percent on an annual basis. Same target to private investments, same exact managers. The only difference is that institution B skips vintage years. So let's take a look at a portfolio construction perspective. What does the allocation look like for these two institutions? Institution A, that consistent committer, takes about ten years to get to that thirty percent target, and then they hover around that thirty percent target quite nicely there. Institution B, you can see halfway there, they skip right after the great financial crisis. You see that gap compared to where they wanted to be from a strategic policy allocation perspective. It's very, very difficult to try to overcome that gap afterwards, and they have that persistent underweight for the next ten to fifteen years. What does this do to their portfolio? What does the return look like for their portfolio? If we look at their total endowment return, so not just the return of their private equity book, their total portfolio return, institution A met their return objective. Over twenty years, they achieved intergenerational equity. They hit an annualized CPI plus five, seven and a half percent over this time period. Institution b, they weren't able to get there. There's the gap. Fifty basis points just by skipping those vintage years. Same managers, same strategic target, but skipping those vintage years means they did not hit their return objective. So from an intergenerational equity perspective, institution a maintained its real purchasing power. The end of twenty years from a inflation adjusted perspective, just above a hundred million, still providing that same level of support in real terms to its mission, institution b, ninety four million. They've eroded their real purchasing power, and this has real implications. That means that now when they go to their grantees or they give scholarships to their students, they're only providing from a real perspective ninety four cents on the dollar. That's a real impact. That's a huge gap at the end of the day when you think about mission. And that's all from just skipping two vintage years. So this concludes our prepared comments. When you do these type of presentations, they always recommend that you leave the audience with one key takeaway. Our one key takeaway is, please mind the gap. Don't let this happen to your portfolio. Make sure you maintain discipline, commitment, pacing and achieve vintage year diversification. So thank you very much for your time. Any questions? Again, we are fifteen minutes away from the beach of from lunch, but any questions? Can I ask, to what extent are the are the top quartile managers knowable in advance? Is is Is this kind of like saying, well, we would do better if we didn't invest in the S and P five hundred, but only the top quartile of the S and P five hundred? The question is to what extent we know that Can you know which are going to be the top quartile managers? You never know, but when you're thinking about private equity and venture capital, actually on venture specifically, the persistence return of those top quartile managers is very persistence. So that those that have performed or have stay on top top quartile, they have historically been able to keep at that level of return. So it's never assure, but what we've seen is especially when you're thinking of venture, there's so much persistence on those top quartile managers that it is expected that you you you could continue to see. It is a very close ecosystem at the Valley. The entrepreneurs want to kind of be raising capital with the same funds. So there is some persistence of those top performing managers being able to deliver top performing top quartile funds cycle over cycle. Thank you very much. Please remember to complete a brief session evaluation on our format.