On a quest for greater returns with less risk and volatility, institutions have diversified into alternative assets in search of niche, alpha-generating strategies. For some that means direct investments into firms, and for others that means investing with small or new managers.
In this week’s Trusted Answers, we look at how you can diversify your portfolio:
We invest across all asset classes in the diversified portion of our portfolio. We classify our assets around various risk exposures, liquidity, deflation and inflation, with the largest portion in capital appreciation assets. Our hedge funds are separated into lower and higher volatility allocations. Running across our entire portfolio is a cash flow and value bias.
There is an allocation for venture capital within our private equity allocation. Private equity investments are across growth equity, buyouts, distressed investments and mezzanine and venture capital.
We haven’t been active in the traditional VC space, at least not in any significant size. Initially, we've stuck close to our knitting. We have invested in some private markets in the financial sector and specifically in Europe...
...Our largest private equity deal is in the food services. It does have a European presence, but it is primarily supporting the U.S. hospitality industry. That's an area where we see growth. We are looking overseas for expansion in that particular enterprise.
That’s a deal where we invested for control but increasingly we are looking to co-invest. There we were a little bit less industry-centric, but our focus has been less on the traditional VC, tech startups; as opposed to early stage investment in a relatively stable cash flow business that has discernable growth potential. We are relatively agnostic whether it is a domestic-centric company or one that has international aspirations, but that being said on the liquid-market side we have been very active in Europe. From a growth potential, if we were looking overseas, we would be looking at Europe primarily.
...On the liquid side, we did have fairly significant exposure in Asia and EM economies earlier in the year. That was really predicated on the thesis around declining energy prices being beneficial and simulative to certain economies. We started exiting that position and have significantly reduced EM in general, and Asia in particular, after the Chinese devaluation. I don't expect that we are going to be very aggressive in adding exposure in that area.
We’ve also reduced EM globally, partially in response to the dollar and partially in response to global growth declining the commodity markets. We feel that it disproportionately impacted that sector. I would say for the most part, we have a fairly North American-centric focus within the portfolio both in the public and private side. But we have been more opportunistic in Europe.
At this point, versus 2005, our broad asset allocation is quite similar to that of our large endowment peers.
One of the things that is different for us and for some of our other peers is that Hopkins, very early in the 1980s, decided to invest in private equity. They were a pioneer. Unfortunately they dropped out in 1989. The investment committee was concerned about liquidity and having enough liquidity. So they stopped making commitments to private partnerships. Then in 1993 or 94, they did the same thing that the NYU investment committee did, they moved heavily into fixed income. They were just nervous about equity market valuations. So Hopkins basically missed the 90s in private equity and venture capital and also in public equity because they were under allocated.
When I came, my mandate was to build out the portfolio and that’s what we have done. I think we have been very successful at getting into a certain number of funds that are very much in demand.
The one thing we have very little of is venture capital. In a year like this past fiscal year when those that had 5% and 10% of their portfolio in venture capital and saw fabulous returns, we simply did not participate. Although, our small venture capital portfolio did very well. I think it did more than 40%, but it’s like 1.5% of the portfolio. One of the things that is interesting to me is the fact that, compared to what I thought when I came, those few VC firms that were very much in demand became even more in demand. One of the decisions you have to make is how much time do I spend knocking on doors that may never open. That’s one aspect of the portfolio.
While we are now about 50% in alternatives, we still have more public equity than some of our peers. We are overweight and have been overweight for a while to international public equity in part because we thought it was undervalued and in part because we have some really, really good managers who have generated alpha.
We’ve been overweight emerging markets. We thought we were quite overweight, but we actually looked at an asset allocation survey of our peers and we realized that several were even more overweight than we are. Again, that’s a long-term allocation. It certainly hurt us over the last year. We were able to add to some of our managers over the summer and the fall. So hopefully we are buying in at lower valuations.
...We are looking to run a more focused portfolio within private investments. We have spent the last three years repositioning our private portfolio and feel good about both its composition and exposure. Coming into 2016, we had quite a bit of dry powder in distressed, and we feel good about the exposure we have there. We have been legging into growth opportunities with managers committed to lower middle market and / or an expertise within a particular sector.
We've chosen to structure our private equity portfolio with more of a barbell approach and with the commitments made over the past three years now have a more balanced private equity book. The other piece of our private equity book is venture capital. We have had some success in building our VC exposure and continue to look to add exposure to leading VC firms that have demonstrated their ability to access the best and brightest entrepreneurs.
The endowment is now $1.3 billion, and there’s another $300 million in working capital. It’s about $1.6 billion in all that we are managing at the investment office. The strategy is now in its tenth year of allocating to alternatives in a meaningful way.
Ten years ago there was a new chair on the investment committee, and the investment committee decided that the university should be investing in alternative investments in a meaningful way. In the first couple of years, some commitments were made.
Then the university decided to staff up. They hired my predecessor and then I was brought onboard in December 2007. So you can imagine not a whole lot of transformation happened in 08-09 as we went through the global financial crisis.
As we came of out of the global financial crisis, we had made commitments in the prior years that were starting to generate some liquidity events in 2011 and 2012. Since then it’s been a steady state with respect to making consistent commitments.
We are over-allocated on some asset classes and under-allocated on others. Overall, we are looking to be a pretty steady state with respect to having a significant allocation of around 30% to private equity, defined as venture capital, growth and buyouts.
At the broad level, we are about 75% of equity and 25% of fixed income. Within the equity space, I’d say about half are in the alternatives investment arena including hedge funds, private investments in venture capital, private equity, real estate and energy, and the other half are in the public equity long-only positions, spread across U.S. and non-U.S. developed, emerging and frontier markets, across the value and growth spectrum and across market capitalizations. Specifically regarding EM and Frontier, even though it has been a very unattractive asset class recently, I still am a believer in EM and frontier markets, so I’ve been maintaining my positions...
...On the venture side, because of our size, it is challenging to get direct access to best venture capital firms. As we all know, the difference in performance between the first quartile manager and non-first quartile manager is significant. So historically, we have been using venture fund of funds to get access to these top quality venture capital firms, but given our current AUM size, we are now looking to make direct investments into quality venture capital firms.
...We probably run liquidity as close to what the endowments run without taking excessive liquidity risk. We have a mature private equity portfolio and venture portfolio, natural resources and real estate. That portfolio is roughly 35% of the book. That’s not as high as where Yale carries it, but it's good enough for us. It's a high enough level for us. We feel that we're earning enough of the liquidity premium in the top managers.
We believe that in the long run, we’ll see an emerging class of middle class consumers in a number of the emerging markets. You are already seeing that in China. You are hearing a lot about that in India.
Taking into account all these things, we remain very committed to the emerging markets in the long run. We think things will go better. We also believe that we have to approach it in a sustainable manner. After all, if you consider the carbon footprint of an average American versus the carbon footprint of someone living in China or someone living in India, and then think of how economically these countries will grow and that people will consume more. Clearly, there is not enough of a resource base in the world to accommodate this type of growth over time.
I think it’s going to be very, very important to find a way to invest into, let’s call it, the sustainable emerging consumer in these countries.
Alan Chang, Partner and Managing Director, Capricorn Investment Group (investment arm of Jeff Skoll’s family office)
Read the full interview here.
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