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Don Steinbrugge, founder, Agecroft Partners

Comment: Endowments and Foundations are back and better than ever as active allocators to hedge funds

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Don Steinbrugge (pictured), Chairman of Agecroft Partners, looks at how endowments and foundations are rediscovering their appetite for hedge fund allocations…

Large Endowments and Foundations were early adopters of hedge funds in their portfolios with many allocating approximately 50% of their asset allocation. However, in the two years following the financial markets meltdown, these same investors stayed primarily on the sidelines for new hedge fund allocations. Over the past six months, Agecroft Partners has seen a significant increase in the search activity for endowments and foundations and expects this trend to continue for the foreseeable future. In addition, Agecroft also sees this trend applying to mid-sized endowments and foundations, who historically had a much lower allocation to hedge funds. Agecroft is in contact with a majority of the largest endowments and foundations on a regular basis. When contacting these organisations a year ago the typical response was, “We are on hold and not allocating to new managers,” versus today’s reply of, “We would welcome a meeting and are very interested.”
 
From the 4th quarter of 2008 until the 4th quarter of 2010 many large endowments and foundations suffered through significant issues driven by a lack of appropriate liquidity forecasting that included not only the needs of the organisation, but also the potential private equity capital calls, and suspension of redemptions from their hedge fund managers. Until the end of 2008, these organisations were over committed to private equity believing this was the appropriate strategy to reach their target allocation. Their recent experience had shown that a large percentage of their private equity capital calls were offset by managers returning capital. As the IPO market dried up and the financial crisis at the end of 2008 ensued, the return of capital grounded to a halt. At the same time, capital calls reached all time highs as private equity firms saw once-in-a-lifetime opportunity with valuations at historic lows. This created terrible liquidity problems for some of the leading endowments and foundations, forcing them to liquidate some of their private equity holding on the secondary market. With stable markets and better returns, most of these liquidity problems have corrected themselves and freed up capital to invest in new managers.
 
During this same time period, many endowments and foundations were also unfairly criticised for the short-term market value declines their portfolios had sustained due to unrealistic performance expectations, while some people even questioned the whole concept of the “endowment model” of investing. This concept was pioneered by the Yale and Harvard endowments that allowed hedge fund managers to compete head-to-head with long only managers utilising best-of-breed criteria, as opposed to viewing hedge funds as a separate asset class. These portfolios tend to be primarily invested with alternative investment managers, including large allocations to hedge funds. It was this strategy that allowed these organisations to generate significantly higher returns than the average pension fund and smaller endowments and foundations over the years. The liquidity issues are a fair criticism; however the focus on short term performance was wrong given the long time horizon of their structures. Endowments and foundations that effectively manage their liquidly can accept higher volatility to maximize long term returns.
 
Large endowments and foundations are recognised for their outstanding long term returns and it has revolutionised how small-mid sized endowments and foundations are managing their money. Three years ago the endowment and foundation industry was bifurcated by size where organisations with more than USD1B AUM typically had in house investment teams with a heavy allocation to alternatives, while those with less than USD1B AUM were managed part time by the treasurer, assistant treasurer or controller of the organisation with the help of an investment committee derived from the Board of Trustees. Often local investment firms were chosen to manage the assets in a traditional balanced account utilising equities and fixed income. Many others also utilised the services of an investment consultant. Unfortunately, the average performance of these small-mid sized endowments and foundations significantly under performed the larger endowments costing these organisations millions in lost returns. This is now changing. It is not just the largest endowments that are becoming more active in allocating to hedge funds, but also the mid-sized endowments (USD100 million to USD1 billion). These organisations are undergoing a major transformation on how they manage their portfolios, choosing from several options as they evolve. First, many of these organisations have begun replicating their larger peers by hiring a full time Chief Investment Officer to oversee the portfolios. A ripe recruiting ground for these newly created positions is the under-paid talent from large public pension funds. 2 recent examples are Lehigh University hiring of Peter Gilbert, the former CIO of the Pennsylvania State Employees’ Retirement System and Georgetown University hiring Larry Kochard, former Managing Director of the Virginia Retirement System, who has since taken the CIO role at the University of Virginia.
 
The second development is the proliferation of outsourced CIOs where an endowment or foundation will hire an investment advisor to implement the “endowment model” of managing their portfolio instead of hiring someone internally. The demand for these types of services has been overwhelming, and firms like Investure who boast such clients as The Carnegie Endowment, Smith College Endowment and Colonial Williamsburg Foundation, have turned away potential clients. Other firms with a presence in this space include High Vista who was recently selected by the billion dollar endowment of Rensselaer Polytechnic Institute, Perella Weinberg Partners, Strategic Investment Group and Makena Capital Management, among many others. We are also seeing a new development in the outsourced CIO market place as some endowments are unitizing their fund and allowing other institutions to comingle their assets for a fee. Leading the charge in this area is the University of Richmond which points to several benefits including a major revenue source for the University, creating good will with the local community and finally it is a liquidity source for the endowment. The University of Richmond was one of the only endowments deploying fresh capital during the market correction.
 
This is good news for the hedge fund industry, especially high quality small-mid sized hedge funds that have had difficulty raising assets over the past couple years. Sophisticated endowments and foundations often have a large allocation to these smaller, nimble managers due to their potential to outperform their larger peers. A number of recent studies have confirmed what endowments have known for a long time, including a recent report by the Barclays Prime Brokerage and by Pertrac, The Pertrac report showed that small hedge funds have outperformed large funds over a 13 year period by approximately 3.5% annually. Simply put, it is much more difficult for a hedge fund to generate alpha with very large assets under management. Many hedge funds limit the amount of assets they accept for a particular strategy, but there remains a large financial incentive to grow the fund above its optimal size in light of the strategy. There are other hedge fund organisations that are morphing into large asset gatherers and will grow their funds significantly above optimal levels, at times changing their investment process in order to accept more investor money.  Eventually, the fund may have little resemblance to earlier days when it achieved strong investment returns. There is surprisingly little focus by investors on determining capacity constraints for individual hedge funds. Many investors limit their due diligence on this important question to an interview of the manager, who has an obvious conflict of interest.
 
What is most interesting about this segment of the institutional investor market place, unlike defined benefit pension funds, is the industry’s structure, which allows perpetual growth. There are three reasons for this:  first, they typically only payout 4% to 5% of their assets each year, which allows them to grow at a quicker rate than inflation; second, they are continually receiving additional donations; lastly, new endowments and foundations are being created at a record pace by a new generation of the super-rich, who have made their fortunes from the technology, hedge fund and private equity industries.

Unfortunately, only a small percentage of hedge fund managers will be successful in acquiring assets from what has become a highly sophisticated and competitive market place. Many of these investors utilise a process of elimination in selecting hedge funds to narrow down the thousands of firms that contact them each year to the couple hundred with whom they meet and ultimately the two or three they eventually hire. A blemish in any of the evaluation factors utilised to select hedge funds will cause a fund to be knocked out of consideration. In addition to hedge funds needing to have a best in class offering to secure business from the market place, it is also critical that the marketing message is fine-tuned to be concise, linear and clearly articulating the differential advantages across all the factors used to evaluate hedge funds. Unfortunately for most firms, there is a divergence between market perception and reality due to poor presentation skills. Finally, it doesn’t do any good to have a strong offering if no one knows about it. This market requires a highly professional, proactive and knowledgeable sales force. This can be done internally or by leveraging the strength of a top third party marketing firm who can help guide the institutional investor through the lengthy due diligence process.

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