12-9-09: Princeton: Inside the Vault: Private Holdings

Just because the University has a $12.6 billion endowment doesn’t mean that it can quickly come up with $12.6 billion to spend on any given day. In fact, the University can only convert about half of its endowment to cash with ease. The other half is made up of illiquid assets, like private equity investments, which are more difficult to sell on short notice.

This short-term sacrifice is a necessary part of the University’s investing strategy, aimed at better performance in the long run, Princeton University Investment Company (PRINCO) president Andrew Golden said.

A key part of this strategy is the University’s reliance on private equity investments, which comprise roughly a quarter of the endowment.

These investments in small, privately held companies will hopefully soar as those companies grow and perhaps go public. Until then, though, private equity investments are very difficult to sell. In return for this illiquidity, investors hope for better returns.

“The price of a company tends to be less because it’s illiquid,” Golden said. “And when you own a company privately, you have greater flexibility in creating value for the company, because you don’t have to report your results every quarter to Wall Street. You can dampen profits in the short term rather than in the long term.”

Over the past 10 years, the returns on the University’s private equity portfolio have been nearly 10 percent, Golden said. The value of that private equity portfolio dropped between 20 and 25 percent last year, less than the 26.2 percent decline in the S&P 500, he added.

During his tenure with PRINCO, Golden has gradually increaseåd the University’s private equity holdings. In 2005, roughly 15 percent of the endowment was invested in private equity, but by 2008 that figure had risen to 25 percent, according to reports from the Treasurer’s Office.

This trend is in line with the investment model pioneered by Golden’s former boss, Yale Chief Investment Officer David Swensen, said James Clark Jr. ’60, a retired general partner at the investment firm Tweedy, Browne. When Swensen took over Yale’s endowment, he revolutionized the world of institutional investing by foregoing liquidity in favor of the higher returns of illiquid assets. Under Swensen, Yale’s endowment grew from a mere $1.3 billion in 1986 to more than $22.9 billion at its peak in 2008.

But some have questioned the wisdom of this reliance on illiquidity, especially given the current economic climate.

“Nobody seems to comprehend the fact that there’s a fundamental disconnect between what the endowment’s supposed to do and how it’s structured,” said Tad LaFountain III ’72, a former investment manager for the University of Richmond.

Every university wants a large endowment, but it’s not always clear exactly what that money is being saved up for. Each year, the University aims to spend between 4 and 5.75 percent of its endowment, though this year it will spend about 6.04 percent.

The obvious purpose of the endowment is to fund University initiatives and operations, which are run on an annual basis. Presumably, the endowment should be able to summon up cash quickly, even in times of crisis. It should satisfy the yearly demands of the University first, LaFountain said, and only then go after long-term returns.

Yet there are some who find fault with the nature of university endowments and the way they are spent.

“I’ve been particularly unhappy with the tendency in recent decades toward spending rules constraining spending out of the endowment to a given fraction of the endowment’s income, which tends to make the university’s operating budget a buffer for the stock market,” Henry Hansmann, a Yale Law School professor and leading critic of how universities spend their endowments, told The Yale Herald in February 2008. “It should be just the reverse.”

An analysis of Harvard’s endowment in The New York Times suggested that the assets that university tied up in private equity will make it difficult for it to meet its annual obligations, meaning that investors may be required to contribute some money to the fund every year.

The percent of Princeton’s endowment in private equity has crept up steadily over the past several years. This has also been the case, on average, for many university endowments across the country.

“I would be highly critical of something that is illiquid in an endowment portfolio,” said a former PRINCO investment manager who spoke on the condition of anonymity. “Would you want that much stock at risk without any potential to sell it in your portfolio?”

When the stock market is in turmoil, as it has been over the past year, illiquid assets could make up a far larger portion of the endowment than planned.

“I think the big danger is … facing us right now,” the former PRINCO manager said. “Our economy and our political background and our financial background are all in very, very delicate shape. Because of that, these illiquid positions look even higher risk than they did a few years ago.”

If one of the small companies the University has invested in goes sour — which is much more likely in the current economic climate — then the University will find it difficult to shed its stake in that company quickly. Therefore, it faces the prospect of heavy losses that it can do very little about.

The former PRINCO manager added that it’s also impossible to tell how much these illiquid investments are worth. Because there is almost no active market for them, the University cannot gauge their current value with accuracy.

LaFountain pointed out another potential problem in how PRINCO determines the value of its illiquid investments, citing a potential conflict of interest. Because the investment managers hired by the University to seek out good private equity opportunities almost always take a cut of the total value of the assets they hold, they may be tempted to exaggerate the assets’ actual value, LaFountain explained.

“The people who are paid fees predicated on the size of the assets are the ones determining the size of the assets,” he said. “You can bet our dollar that they’re not tending towards the conservative.”

LaFountain also said that those pumped-up values could be artificially inflating the 9.7 percent annual return on investments that PRINCO claims for the past 10 years. He called for a closer examination of the true value of PRINCO’s assets.

“If the University spent more time worrying about asset inflation and less about grade inflation, it would be better for everyone,” he said.

In written testimony for Congress in 2007, Golden said that PRINCO vets its investment managers thoroughly. PRINCO spends upwards of 400 hours researching hedge funds before making decisions, he said, meeting repeatedly with the fund manager, examining the portfolio and speaking with references.

“There have been instances where hedge funds that we chose not to invest with because of insufficient transparency have gone on to produce fantastic results,” he said in the testimony. “I have no regrets regarding those decisions.”

But illiquid assets may not pose as great a risk for PRINCO as they do for most other investors. In traditional hedge funds, investors can typically ask for their money back, which means that the fund has to have enough cash on hand to satisfy those demands. Because the only investor in PRINCO is the University, that is not an issue.

PRINCO has some “natural advantages” in that area, Golden said.

“We can tolerate illiquidity, and we have access to the world’s best investors in the area,” he explained. “If you have much larger assets than Princeton has, [private equity] might not have a huge impact on your bottom line. If you have fewer assets, you might not be able to cost-effectively do the research.”

Tom Byrne ’76, who heads his own asset management company, said the University’s prestigious status could help it secure private equity opportunities unavailable to many other asset managers, especially because of its large alumni network.

And because PRINCO maintains a long-term focus, some managers say illiquid investments aren’t necessarily a bad thing.

“The fact that private equity is illiquid should not in itself be a disadvantage if you’re an endowment and you have your funds forever,” Clark said. But he added, “If you’re going to invest in private equity, you’ve got to have short-term liquidity requirements in very, very liquid securities.”

http://www.dailyprincetonian.com/2009/12/09/24690/