University endowments and charitable foundations have been increasing their allocations to private markets and other alternative investments, but some in the sector are growing concerned about whether even these ultra-long-term investors should be tying up their capital for so long.
Funds trying to diversify their portfolios have been putting money into non-traditional assets, such as private equity and private debt, in recent years. They have also been attracted to infrastructure and real estate assets for their potential to offer protection against inflation.
Often, these endowments and foundations have funded these increased allocations by reducing their traditionally-high exposure to mainstream equities or bonds. Larger funds have tended to lead the way in this shift, with mid-sized and smaller funds following their example — and demand from many of these investors remains strong.
“We’re seeing greater interest in assets outside of listed equities and bonds,” says Ben Johnson, senior director at professional services firm WTW. “[It’s] private equity and debt.”
He also notes that “We’re starting to see a broader set of assets filter down through the size spectrum” of endowments and foundations.
Typically, these funds support a diverse group of non profit organisations in areas such as healthcare, education and community work — and, as such, they tend to adopt strategies with a longer time horizon than other institutional investors, such as corporate pension funds.
That gives them greater flexibility when deciding whether to invest in assets such as private equity, which typically locks up investors’ money for up to 10 years, or to buy highly illiquid infrastructure assets.
A survey of 115 endowments and foundations from 24 countries by consulting group Mercer published late last year found that more respondents had increased their allocations to private equity than to any other asset class over the past three years. Infrastructure was also “gaining more attention”, the survey found.
90%Proportion of endowments and foundations holding $1bn or more that are investing more in private markets
Bigger funds were much more likely to have moved into private markets: 90 per cent of respondents holding $1bn or more in assets had either already invested, or were planning to invest in the next 12 months, in private markets, compared with 21 per cent of participants with less than $50mn in assets. Smaller funds, though, have been increasing their exposure, too, as pooled funds make these private markets accessible to investors that are unable to commit a large amount of capital.
“Not needing high levels of liquidity and not chasing short-term returns allowed the larger endowments and foundations to invest greater proportions of their portfolio in private markets and helped to drive strong risk-adjusted returns,” observes Odi Lahav, global head of digital products and chair of investment advisory at Apex Group.
However, there are growing concerns about the flood of money that has been directed towards private markets over the past decade — private equity funds, for instance, are sitting on trillions of dollars of “dry powder” capital yet to be invested.
Some in the sector also worry about the accuracy of private market valuations, which are conducted much less frequently than in public markets.
This is making some endowments and foundations question the attraction of the so-called “illiquidity premium” — the supposed excess profit earned in return for locking up one’s assets for a longer period.
“The question of illiquidity premium comes up a lot,” says James Lewis, UK chief investment officer at Mercer. Even so, he points to the “consistent outperformance of private over public markets” and points out that clients can invest in stages to reduce the danger of buying at a bad time. “Clients believe there is a benefit to locking money up in private assets,” he concludes.
But WTW’s Johnson believes there are “questions” about whether, “in a higher interest rate environment, will [very strong returns] continue?” He sees value in those private equity funds that are trying to improve the operating performance of mid and smaller-sized companies — rather than the funds engaged in buyouts of very large listed companies.
Some endowments and foundations have already adjusted their positions. Harvard University’s endowment — a significant investor in private equity with 39 per cent of its assets in this market — sold nearly $1bn of private equity funds in the secondary market during the summer of 2021, believing valuations would eventually come down. In its latest annual report, it said that “it will likely take more time for private valuations to fully reflect current market conditions”.
Some even question whether — in spite of endowments’ and foundations’ longtime horizons — private markets are the best place to be right now.
“At a time of heightened macro uncertainty, the ability to nimbly turn your portfolio into more defensive instruments is worth lower returns in the short term,” argues Mario Unali, head of investment advisory at Kairos Partners. “Institutional investors are increasing illiquid investments just when liquidity finally became valuable again,” he warns.
Mercer’s Lewis reckons investing in very long-term assets, such as infrastructure, can still offer benefits in terms of inflation-linked returns, but also acknowledges disadvantages — for instance, exposure to other risks, such as climate change. Funds did not always have to invest on an ultra long time horizon, he adds.
“An institution can plan to be around for hundreds of years but, when planning its strategy, the investment time horizon isn’t necessarily that long.”