Secrets of Sand Hill Road

by Scott Kupor

  Insurance companies (e.g., MetLife, Nippon Life)—Insurance companies earn premiums from their policyholders and invest those premiums (known as “float”) for when they are required to pay out future benefits. The monies they earn from investing these premiums are then available to pay out the insurance policies as they mature.

  Funds of funds (e.g., HarbourVest, Horsley Bridge)—These are private firms that raise money from their own LPs and then invest in venture capital or other financial managers. LPs of fund of funds are typically smaller instances of direct venture LPs and thus find it difficult or economically inefficient to invest directly in VCs—e.g., they might be university endowments or foundations with less than $1 billion in assets, such that hiring an in-house team to cover venture capital relationships may be prohibitively expensive. The fund of funds aggregate small LP assets and deploy the capital into VCs. Unlike the other categories of LPs, fund of funds are not permanent capital; that is, just as with venture capital funds, fund of funds need to go raise money on a periodic basis from their LPs in order to have money to invest in venture capital funds.

  As noted above, while there are lots of potential LPs with varying uses for their capital, the overarching goal of LPs is to earn a return on their money that enables them to satisfy their mission.

  The mission for a university endowment, for example, is to be able to provide a predictable stream of revenue from which to cover the many operating expenses associated with running a modern university. In many cases, university endowments contribute between 30 and 50 percent of the annual operating expenses for a school.

  Inflation (in its many forms) is the kryptonite to the long-term success of LPs. University endowments worry most about inflation in their expense drivers (namely, salaries for professors and administrators), which has outstripped regular inflation significantly over the years. Foundations worry about generalized inflation that eats away the purchasing power of its dollars (and thus its ability to make grants). Insurance providers, of course, worry about the same—if inflation exceeds the returns on their investments, the real purchasing power of their assets declines and can make it difficult for them to be able to pay out insurance claims in the future.

  But in trying to increase the real value of their investments, LPs don’t just invest in VCs; they construct a diversified portfolio around a defined asset allocation to try to achieve their return goals, but within a defined volatility (or risk) framework.

  Where LPs Invest

  Generally speaking, the types of investments to which LPs allocate capital fall into three big buckets:

  Growth assets—These are investments intended (as the name suggests) to earn returns in excess of what less risky assets (bonds and cash) are expected to earn. There are several subcategories of assets within growth:

  Public equities—Stocks that trade on public market exchanges. Most LPs typically have some allocation to US domestic equities, developed international country equities (e.g., Europe), emerging market equities (e.g., China, Brazil), and frontier market equities (e.g., Indonesia). Within these geographic areas of focus, some LPs will also have specific targets for types of equities—e.g., small cap versus large cap, and value versus growth.

  Private equities—Stocks that do not trade on public exchanges but are instead managed by funds that transact in privately held companies. Buyout firms are a big category of private equities; VC is in this category as well.

  Hedge funds—Funds that invest mostly in publicly traded equities but have the ability to take both long (i.e., buy a stock) and short (i.e., bet that a stock will decline in price) positions. There are lots of different types of hedge funds, to name a few: long-only funds, long/short funds, event driven (e.g., they invest in equities where the company might be going through an acquisition), macro (e.g., they are making an investment bet on a country’s inflation outlook, currency movements, etc.), or absolute return (they aim to meet a defined return target independent of overall market movements). Some LPs have differing views on the role of hedge funds in the portfolio. In some cases they are thought of as regular growth assets—meaning that they should yield equity-like returns and thus provide asset appreciation to the portfolio. Other LPs think of hedge funds as closer to diversifying (or, as the name suggests, “hedging”) assets; that is, they look for hedge funds whose returns are not correlated with the overall equity markets so as to provide a more balancing effect on overall returns depending on whether equity markets are up or down in a given year.

  Inflation hedges—These are investments meant to protect against the decreasing value of a currency. In other words, in an inflationary environment, they are expected to earn a rate of return in excess of inflation. There are several subcategories of assets within inflation hedges:

  Real estate—Rising inflation should increase the underlying value of a property holding and, in most cases, as inflation rises, the landlord can increase the rent she collects from tenants.

  Commodities—Gold, silver, and other precious metals tend to increase in value with inflation as people look to them as stores of value in an environment where currencies are inflating.

  Natural resources—Investments in oil and gas, timber resources, and agriculture also tend to be viewed as inflation-protecting assets. Inflation often accompanies economically expanding environments, driving demand for raw materials needed to sustain that growth; thus, natural resources pricing is expected to outpace inflation.

  Deflationary hedges—When prices drop (deflation), the purchasing power of currency actually increases. To take advantage of this, LPs often hold some portion of their assets in the following:

  Bonds—In general, interest rates fall with deflation and, because the value of a bond is inversely correlated with interest rates, bond prices increase.

  Cash—A dollar tomorrow in a deflationary environment is worth more than a dollar today. Thus, holding some assets in cash provides a hedge against unexpected deflation.

  Depending on the overall return target an LP is trying to achieve, its willingness to accept volatility in investment returns, and the time horizon over which it is willing to tie up its capital, an LP will construct an asset allocation from the above mix that marries all these objectives.

  And LPs will try to achieve some element of diversification, meaning that they don’t have too many eggs in one basket and hold some combination of assets that might be uncorrelated with one another in case the overall investing environment moves wildly in one direction or the other. Of course, you know what they say about the best laid plans: as the 2008 global financial crisis illustrated, many assets that LPs had previously thought were uncorrelated turned out to all move in the same direction—down!

  The Mighty Bulldog

  One of the best examples of modern asset allocation is the Yale University endowment. Its current, and long-standing, chief investment officer is David Swensen, whom people credit with designing the allocation model that many leading institutional investors follow today. There are Yale acolytes who are now running a large number of other US-based endowments and foundations, thus helping to introduce the Yale endowment model to a variety of other institutions.

  Interestingly enough, Yale came to its current asset allocation model on the heels of a disastrous run of investment returns. From the late 1930s until 1967, the Yale endowment was composed almost exclusively of bonds, specifically treasury bonds. The strategy proved costly, as the endowment missed out on one of the great equity bull markets in US history. To remedy this, the endowment (at the height of the equity bull market) invested heavily into small-cap stocks in 1967, ultimately liquidating this position at a material loss in the late 1970s.

  Swensen joined the endowment in 1985, when the total assets were roughly $1 billion; more than thirty years later, the endowment tops $25 billion. Of course, alumni have donated money over time as well to he
lp increase the size of the endowment, but over the last ten years, the Yale endowment has returned more than 8 percent net from its investment allocation, ranking it among the very top educational institutions.

  The endowment’s main purpose is to provide a steady source of funding to the university. In 2016, the endowment contributed $1.15 billion to the university, accounting for one-third of the institution’s revenue. Maybe surprisingly (it was to me), tuition and room and board that Yale’s student population paid amounted to only about $333 million that year, or about 10 percent of the total university budget.

  Given the magnitude of the university’s reliance on the endowment to keep the lights on, predictability of the endowment’s contribution is pretty important to Yale. If the contribution were to swing wildly from one year to the next, for example, Yale, which has a high fixed expense base (mostly employee salaries), would be forced to hire or fire employees from one year to the next. Alternatively, Yale could significantly adjust the amount it takes from the endowment, but that would make it hard for the endowment to know how much of its assets it could hold in liquid versus illiquid investments, making longer-term asset allocation planning more difficult. Finally, since the goal of the endowment is to be perpetual and to grow its assets over time, if the endowment had to provide more cash to the university every time the stock market were down, the endowment returns would likely suffer as a result.

  To address this challenge, Yale uses what’s called a “smoothing model” to determine the amount of money it contributes each year to the university’s budget. This enables the university to plan its expenses with more certainty and allows the endowment to plan its asset allocation model with more certainty as well. By definition, the smoothing model says that the endowment will give the university an amount equal to 80 percent of the prior year’s spending rate plus the product of 20 percent of the board-determined spend rate and the value of the endowment from two years prior. Currently, this adds up to an overall spend rate of around 5.25 percent of the endowment’s value, but it has ranged over time between 4 and 6.5 percent.

  So what does that tell you about the kind of returns that the Yale endowment needs to achieve to sustain its financial commitment to the university and ultimately grow the value of its assets? At a high level, if inflation is currently running a little north of 2 percent, and if the endowment needs to contribute 5.25 percent of its assets every year to the university, then the endowment’s investments need to earn at least 7.25 percent in gross returns to grow the asset base. Luckily, as we said above, the endowment has been generating just north of 8 percent annually over each of the last ten years. Mission accomplished.

  Let’s now turn to Yale’s actual asset allocation to understand how it intends to keep achieving these results and ultimately the role that VC is playing in the endowment.

  Here’s how Yale is allocating its growth assets:

  Domestic equities—Yale has a 4 percent allocation to US publicly traded stocks; over the last twenty years, Yale’s domestic equity portfolio has returned about 13 percent annually. Note that the average university endowment has about 20 percent of its portfolio in domestic equities. Yale’s decision to invest materially less in these assets reflects a belief on its part that there are other assets that have higher return potential coupled with lower volatility. We’ll see shortly where Yale’s extra dollars are in fact going.

  Foreign equities—Yale has a 15 percent allocation to non-US publicly traded stocks, 6 percent to developed international markets and 9 percent to emerging international markets. As with its domestic equity allocation, Yale’s foreign equity allocation trails the average university endowment by about 6 percentage points. Over the last twenty years, Yale’s foreign equity portfolio has returned about 14 percent annually.

  Hedge funds—Yale calls its hedge fund strategy “absolute return,” meaning that it is investing in this asset class largely to generate high long-term returns by exploiting market inefficiencies with relatively low correlation to broader equity market and fixed income returns. Yale’s allocation of 22 percent to absolute return strategies is generally in line with other university endowments and has returned 9 percent annually over the last twenty years (with the expected low correlation to equities and bonds).

  Buyout funds—Yale has a 15 percent allocation to buyout funds; recall that these are private equity funds that typically buy controlling ownership stakes in existing businesses and seek to increase their value over time by improving their financial operations. At 15 percent, Yale’s allocation to buyout funds well exceeds the 6 percent average among university endowments. Over the last twenty years, Yale’s buyout portfolio has returned about 14 percent annually.

  Venture capital—Yale has a 16 percent allocation to our good old venture capital category, again way in excess of the 5 percent average among other university endowments. And, boy, has this paid off for the Yale endowment; over the last twenty years, Yale’s venture capital portfolio has returned about 77 percent annually. No, that is not a typo—basically, that means that Yale has been doubling its money in venture capital every year for the last twenty years!

  If you add all of that up, the Yale endowment is allocating 72 percent of its endowment to growth assets. That makes sense when you think about the financial obligations the endowment has to the university and the need to keep pace with university inflation, which has been well in excess of more generalized price inflation.

  Here’s how Yale is allocating its inflation hedging assets—a total of 20 percent of its assets are geared toward protecting against unexpected inflation:

  Natural resources—Yale has a 7.5 percent allocation to oil and gas, timberland, mining, and agriculture assets, each of which is intended to protect against unexpected inflation and generate near-term cash flow. At 7.5 percent, Yale’s allocation is generally in line with the average university endowment. Over the last twenty years, Yale’s natural resources portfolio has returned about 16 percent annually.

  Real estate—Yale has a 12.5 percent allocation to real estate investments, well in excess of the 4 percent average at other university endowments. Over the last twenty years, Yale’s real estate portfolio has returned about 11 percent annually.

  The smallest portion of Yale’s endowment is targeted to deflation hedging assets—7.2 percent, well below the 12.7 percent allocation of the average university endowment:

  Fixed income—Yale has a 4.9 percent allocation to bonds, which are intended to protect against unexpected deflation and to provide near-term cash flow. Over the last twenty years, Yale’s bond portfolio has returned about 5 percent annually.

  Cash—Yale has about a 2 percent allocation to cash.

  A couple of big-picture things stand out when looking at the Yale endowment portfolio.

  Yale has a heavy concentration in illiquid assets—Yale targets to have about 50 percent of its endowment in illiquid assets (essentially funds where the money is tied up for longer periods of time). Yale’s investments in VC, buyout, real estate, and natural resources fall into this category—as of 2016, they added up to about 51 percent, so pretty much on target. Swensen’s view is that illiquid markets tend to have less efficiently priced assets; thus, there is more opportunity for smart asset managers to capture above-market returns.

  Yale also relies heavily on external asset managers versus doing most of its investing directly in-house. Harvard most notably experimented with running much of its endowment in-house before abandoning that strategy, but Swensen has been a longtime proponent of external managers. In fact, most of the due diligence that the Yale team does in analyzing investment opportunities is to analyze what makes a manager unique and how appropriately aligned they are with the endowment’s overall long-term financial goals.

  Before we leave our friends in New Haven, let’s take a final look at the role of VC in the
Yale endowment.

  As we noted, Yale has an outsize asset allocation to venture (at least relative to other university endowments) and has been paid handsomely over the last twenty years as a result. While I don’t think the Yale team expects to earn 77 percent annually forever (in fact, their 2016 report mentions a target annualized return of 16 percent, and they have realized about 18 percent annually over the last ten years), regardless of the actual number, Yale is indeed looking for venture capital to be a high absolute and relative return driver to the portfolio.

  Note the significant difference in Yale’s VC returns over the twenty-year period (77 percent) compared with its returns over the last ten years (18 percent). The dot-com bubble that we talked about earlier in the book created an incredible return for VC firms and their LPs in a very concentrated period of time in the late 1990s. While 18 percent returns are nothing to sneeze at, Yale’s experience gives you a good idea of how outsize venture returns can be in good vintages as well as the variance that can occur in less buoyant times. Most experienced institutional investors will tell you that this reinforces the need to “stay the course” in venture investing throughout stock market cycles. Missing a great vintage can be the difference between realizing long-term outsize returns in VC and not getting paid adequately for the risk and illiquidity of the asset class. Yet again, our friend the power-law curve enters the story.