Investment

Across the pond

Many UK charities have been attracted by the returns achieved by some US universities, in particular during the 2000-03 bear market. But how has the most recent bear market affected portfolios? Richard Maitland reports

The majority of the larger US endowment funds has significantly higher exposure to hedge funds, private equity and other illiquid but “real” assets than their British and European counterparts. During the 2000-03 bear market, this served them well.

Their hedge funds might not have made them money, but they tended not to lose much either. Their private equity holdings held up remarkably well against a relatively benign economic backdrop and the losses were not significant when compared to the extraordinary gains made in the previous years.

Their exposure to some of the more esoteric real asset classes such as timber and oil & gas partnerships performed well, while property holdings held or increased their value, as they did in the UK. With less in conventionally managed liquid equities, the overall results were very good.

Consequently, many funds in the US (and to a lesser extent in the UK) chose to increase their exposure to alternative and illiquid assets. Unfortunately, faced with a much deeper and longer economic decline, a drying up of credit and the massive liquidity squeeze, such strategies have fared much less well over the recent collapse in asset values.

Poor returns
Of 435 endowment funds surveyed in the US (Commonfund survey, June 2009), the average return over the final six months of 2008 was -24.1 per cent. The return for funds with between $50 million and $100 million was typically between -25 per cent to -30 per cent. A top decile return was -16.2 per cent. This compares to a typical UK endowment fund of -12.6 per cent (WM Total Charity Peer Group Median).

Moreover, these returns don’t cover the dreadful first quarter of 2009. As private equity prices typically lag by as much as a quarter, there is probably further bad news to be published. Many US funds do not yet know the full extent of their losses. So, with the average hedge fund falling by double-digit amounts and private equity returns suffering from the significant leverage so often applied to the underlying investments, US endowments have performed poorly.

And what’s worse...
To compound matters, the typical approach to private equity allocations was to oversubscribe to a range of funds. In good times, this meant that one was able to re-invest the profits received from successful partnerships swiftly back into the industry, thus maintaining the desired allocation within one’s overall portfolio. However, in times of strife, this strategy doesn’t work: capital returning from successful ventures dries up, yet the obligation to commit to young funds continues.

The cash calls have to be met from elsewhere in the portfolio, and given that many hedge funds have “gated” their investors from leaving to protect their illiquid positions from having to be realised at fire sale prices, the buck typically falls on the liquid conventional bond and equity positions. This, of course, results in even higher exposure to illiquid private equity and hedge funds post the forced re-balancing. Matters do not finish there.

US endowments have tended to assume higher overall total returns and thus have felt able to spend 5-6 per cent per annum, rather than the more common 4 per cent seen in the UK. However, given the allocations to lower and zero-yielding asset classes, well over half of spending has to be funded from capital appreciation each year, rather than from the natural income stream of the portfolio. So, in addition to having to sell liquid assets at low prices to support private equity calls, further liquid assets have to be realised to meet agreed spending budgets.

Having worked all of this through, one can understand (but still be surprised by) the rumour that one very large US college endowment will have a 75 per cent exposure to private equity by the end of 2010 unless it can find a way of reneging on their previous commitments. Significant cuts to their budget are now being forced through, including an agreed loss of fellows whom they can no longer afford to fund. And the UK?

So, what does this mean for UK charities?
Interestingly, many US commentators are now calling for a move back to more liquid, more income-oriented, less “alpha-hungry” and a less leveraged approach to investment, with short- and medium-term expenditure covered by very low risk assets and a greater appreciation of matching known liabilities to appropriately liquid assets. The current economic and market strife has reinforced thoughts about what should form the foundation of a robust investment strategy for long-term endowments.

Specifically:
• set reasonable spending targets, probably in the region f 4 per cent to 5 per cent per annum. These should be ased on the likely trend in returns from the mix of assets you own. Do not be driven by assumptions about leverage or fund manager skill (alpha/outperformance). They should not assume (although it can be wished for) that your charity will avoid future asset bubbles. Return projections should come with an understanding of the scale and regularity of future drawdowns, and precise asset allocations should be adjusted to the desired risk/reward appetite of the trustees;
• ensure that 70-80 per cent or more of your annual spending can be met by the natural income stream of the investments you own. By embracing a total return approach to investment, this can give significant flexibility at the margins of the portfolio and across the economic cycle to buy lower and zero-yielding asset classes. However, you should feel uncomfortable if ongoing annual spending needs to be supported by substantial amounts of capital realisation;
• capital to fund projects that will require monies over and above the natural stream of income and that are forecast to occur within the next five years should be earmarked and set aside from longer term monies. Ideally, once a year, trustees should scan the horizon for any anticipated capital spending. If it falls within a five-year timeframe, then you have up to five years to take capital out of the long-term fund and should avoid having to become a forced seller at a bad point in the economic cycle;
• a focus on owning assets that produce reasonable income streams is likely to preclude heavy investment in a number of illiquid, leveraged and zero-yielding assets. While you may invest in such assets, hedge funds, private equity, commodities and other alternative investments are likely to remain at the periphery of charity portfolios; and
• the hunt for genuinely sustainable income requires significant diversification. This means an increasingly international approach to investment. Nobody wants the failure of one industry, sector, company or, for that matter, a country, to cause an irreparable dent in the overall income stream. So, while the majority of charity and not-for-profits spend most of their money in the UK, it is entirely sensible to reduce the domestic bias in favour of an increased weighting in overseas equities.

Richard Maitland is head of charities at Sarasin & Partners LLP. Richard can be contacted on richard.maitland@sarasin.co.uk or 020 7038 7000.

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