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Yale University Investments Office Case

Question 1.) Would you say that Yale Investment Office’s asset allocations are
unconventional for a university endowment? What do you see as the distinct features of
Yale’s investments compared to other endowment funds?

Yes, based on its unique Investment Philosophy which is fundamentally different from other
universities, Yale Investment Office allocates the asset in its unique way and as a result, gets an
outstanding performance result in asset allocation.

Yale Investment Office develops its unique Investment Philosophy from several principles,
which are summarized below.

 Putting weight on equities. Not as the same as bonds which have relatively low
expected returns and perform poorly during periods of inflation in which salaries, a key
factor to the bulk of university’s outlay, can be heavily affected, equities are of more
expected return and perform relatively more stable in the long-run.
 Holding a diversified portfolio. Yale choose to reduce the risk by limiting aggregate
exposure to any single asset class, rather than by timing the market.
 Seeking opportunities in less efficient markets. Yale endeavors to select superior
managers in nonpublic markets and allocates two-third of its investment into illiquid
investments, since the extent that the performance of a manager influences returns in an
illiquid market is dominated but uncritical in a liquid market.
 Utilizing outside managers for all but the most routine or indexed of investments.
The Investment Office, after a lengthy and probing investigations, chooses to hire these
external managers and develops closed client-manager relationships with them, because
external mangers are able to give considerable autonomy to implement their strategies.
 Focusing on the explicit and implicit incentives facing outside managers. Yale tries to
structure innovative relationships and fee structures with external managers so as to better
align the managers’ interests with those of Yale.

By means of its distinctive Investment Philosophy, Yale built up its distinctive endowment
portfolio and annually reviews it to decide on target allocations to various asset classes.
Question 2.) How has the investment Office decided when to make private equity
investments? What explains the differences between the strategy in private equity with that
in other asset classes (e.g., real estate)

There were several principles to deal with the privacy equity investments. First, the
investments office placed a premium on building long-term relationships with a limited number
of premier organizations. Yale investment office’s long experience and good reputation made it a
good client in this area. Second, Yale emphasized private equity organizations that took a Value-
added approach to investing. Yale preferred to get its refund from just buying issues with
attracting price and then sold them at a regular price. Yale wanted more from investing, and the
return should be independent from the market. The third principle was to select organizations in
which the incentives were properly aligned. Yale needed more incentives and wanted the privacy
firms to tie their earning with their investment performance. This was why Yale did not like the
organizations affiliated with larger financial institutions.

Yale’s strategy was to focus on deliberately contrarian segments of the real estate market
where most other investors feared to tread. And compared to that Yale wanted value-added
approach in private equity, it intended to get returns from transaction fees or fees based upon
assets under management in real assets field. In addition to that, unlike in privacy equity, where
Yale participated in funds considered to be the premier institutional funds, few people knew or
even recognized the names of most of their real estate funds because these firms are not well-
known. Last but not the least, Yale did not lose any enthusiasm on privacy equity, but it did lose
some in some parts of the real assets such as oil-and-gas.

Question 3.) How has the investment Office made international private equity investments?
What explains the differences between the performance of its international and domestic
private equity investments?

After the U.S. Market became more competitive, Yale began to look for other ways to
obtain higher returns. This resulted in Yale paying more attention to overseas markets due to the
fewer funds that were competing for deals, which suggested that there may be a possibility for
more attractive valuations. International private equity was already being used by other
institutional investors, but they would typically invest in extremely large funds that were devoted
to European and Asian buyouts. Yale abstained from this strategy due to the difficulty of
evaluating foreign private equity organizations along with conflict-of-interest concerns resulting
from the leading foreign private equity investors being subsidiaries and affiliates of larger
financial institutions. Initially, Yale considered investing in large global private equity funds that
were sponsored by well-regarded U.S. firms but moved away from this approach due to the
“obvious lack of experience and track records of the affiliate firms.” Additionally, most of the
talented venture investors in each country were raising their own funds with no apparent need for
affiliate relationships with larger firms.
The risk involved was extreme, as shown through Yale’s small investment in a Russian
“quasi-private equity” fund. This fund was extremely successful in the mid 1990’s (Exhibit 8)
but Yale decided to take a large amount of money from this fund and reinvest it in other
ventures. In 1998 the fund experienced sharp negative returns due to the debt crisis of Russia
which could have resulted in Yale losing an alarmingly high amount of its investment.
Eventually, Yale was able to identify a number of emerging market funds, particularly in China,
that resulted in successful returns. These emerging market funds were “small entrepreneurial
firms with operational experience on the ground in these emerging markets, some co-investment
and/or incentive fees, and an apparently keen sense of where upside opportunities might lie.”
These firms were able to identify undervalued securities in less efficient markets. These
emerging markets were growing at close to twice the rate of developed countries which resulted
in higher rate of returns. This also allowed Yale to diversify their portfolio because the returns of
international private equity tended to “be only partially correlated with those of the U.S. equity
market.”
While International private equity is riskier, if Yale identifies certain market trends in
these emerging markets they are able to take home a higher return rate than domestic
investments. Domestic private equity has also been risky as domestic private equity had been
subject to the “boom-and-bust” cycle since the 1960’s which resulted in periods of growth,
followed by periods of loss. From the 1960 to recently, the market has become flooded with
multibillion-dollar funds that fail to follow innovative strategies that could generate higher
returns. Additionally, many overseas investment institutions began to invest in the U.S. private
equity market in a very undisciplined manner. This resulted in intense price competition. It also
made obtaining substantial allocations to quality private equity funds very difficult for Yale due
to the “intense demand for these funds from limited partners in these overseas firms.” In sum, the
reason why the International private equity investments had such a positive rate of return was
due to the emerging markets being less efficient which provided more opportunities for larger
returns as opposed to the developed markets, such as the U.S. This explains why Yale has
increased the asset allocation for foreign equity, while decreasing the asset allocation for
domestic allocation. It also explains why Yale had a return of 35% from foreign equity in 2006,
as compared to 16.4% from domestic equity. (Exhibit 7)

Question 4.) How is the private equity industry changing? How could Swensen’s private
equity strategy go wrong?

The private equity industry had been undergoing a recession, then it turned around,
started picking up rise again. The growth rate had been increasing drastically. Private equity
funds then surely became larger and started having much more huge scale than before. A bunch
of financial companies were building worldwide connections and raising enormous amount of
funds. Dealing with over billion dollars funds was not uncommon any more. Although this
industry were growing so fast, many investors were not. They were not quite experienced and
sophisticated enough to handle this prosperity. So there were not many companies trust them to
give such huge amounts of equity funds, which lead to a very intense price competition as the
supply is more than the market demand. And this result put big impact on this private equity
industry and made this industry more competitive and much harder.

The reason that Swensen’s private equity strategy could go wrong is because they have to
handle other leveraged buyout companies who have decreased their return system nowadays.
Meanwhile, the risk related to fixed assets or the assets that not easily converted into cash is
getting high. As a result, if the private equity industry is going down, Swensen’s private equity
would lose huge amount of money.

Question 5.) Should David Swensen shift his private equity strategy?

No, there are always two sides to everything. Although the flip side is that Swensen’s private
equity strategy could go wrong, the advantage of the strategy would be quite worthy.

According to the case, although the oversea market is attractive, shifting current
strategies and emphasizing on international market is not a priority for Yale, as the
reasons illustrated below.

 Many of the leading foreign private equity investors were subsidiaries or affiliates
of large financial institutions, which were rife with compensation and conflict-of-
interest problems
 Yale often found it quite difficult to evaluate foreign private equity organizations,
because the absence of a strong network relationships that it could rely upon to
assess the quality of potential new partners
 The international private equity investing carried real risks, because of some
unexpected crisis in other countries.

Although there some deficiencies and obstacles in the domestic private equity market,
Yale should still stay committed to private equity, for rationales below.

 The historical success they had enjoyed. For the past twenty years, Yale
generated an annual rate of return of 27.8%(with a standard deviation of returns
of 38%)
 Over its 30-years investing, Yale had developed strong relationships with key
manager, which served as an important competitive advantage.
 Yale had a considerable understanding of the private equity process, which
allowed it to manage investments in sophisticated ways.
 If Yale were to decide not to invest with a top-tier firm merely because the
market was overheated, it might not be able to persuade the organization to
accept its money when later market condition were more favorable.

Yale university has already gone through the returns that were enormous high and made
investment on some companies which are recognized as the best in the world. If they now
discard or stop their current strategy, they would appear to the public as an unreliable image.
This can definitely hurt Yale’s reputation and result in disability to go back to the market. In
conclusion, keeping their current strategy should be the best choice. It is more like a risk neutral
holding a portfolio, though it has some risk, he could gain a lot of profits if the portfolio goes
well.

Question 6.) Briefly summarize your opinion on the short-term and long-term current
outlook (i.e. at the time of the class) for the main asset classes that David Swensen invested
in at the time of the case
Over the past 30 years domestic equity asset allocation has declined exponentially. It
started at 61.6% in 1985 and dropped all the way to 4% in 2018. Both short and long-term
outlooks for this asset allocation remain stable. Although the average educational institution
invests 19.6% of assets in domestic equities, Yale decided to invest at a much lower rate due to
the “Less than ideal” returns available at such an efficient market. Yale understands that there is
a higher rate of return for the other assets.
Unlike domestic equity, Yale has decided to continue to invest substantially in foreign
equities. It has gradually increased its foreign equity asset location from 1985 (6.3%) to 2017
(14.9%). The short-term outlook seems to remain stable, but as the managers of these foreign
equities discover less-efficient markets that can provide massive returns the asset allocation will
increase. This is why, long-term, Yale will continue to gradually increase the foreign equity
allocation due to the higher expected real returns of the emerging markets in this category.
Bonds has completely failed to exist in todays asset allocation. Bonds provided very low
rate of returns and were a waste of allocation space. Both the short and long-term outlook are
very bleak for Bonds.
Cash has continued to fluctuate over the years and we predict it will continue to do so. It
all depends on the inflation rate and the cost of borrowing money. Since recently, borrowing
money has been cheap, Yale may seem to have an increase in asset allocation of cash short-term.
There seems to be no stability in this area so predicting long-term is difficult with no factors
pointing to a specific outlook.
Yale has been very cyclical with its real assets investment allocation (real estate +
Natural resources). It has gradually increased its asset allocation from 1985 – 2009, but once the
housing market collapses Yale decided to push back on its real estate investments. It has since
settled at around 21% and will continue to increase as the real estate market continues to
strengthen. But, as the real estate market is cyclical, so will the investment allocation. Because
the current real estate market is strong there may be an increase in real assets allocation, but long
term there will be periods of increase and decreased allocation.

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