Endowments' results may be worse than reported

The dismal recent performance by the endowment funds of several Ivy League universities has dimmed the luster of the funds' managers. But the performance of those managers — who in recent years have attained rock star status in the investment world — may be even worse than the numbers indicate. Because endowments have large amounts of illiquid holdings, some of the returns posted in recent years may not have given a completely true picture of performance, observers said. In addition, the funds have taken on more risk than is apparent from their reported results, according to critics, giving a misleading impression of risk-adjusted return. Most of the larger endowments invest in illiquid limited partnerships put together by managers of hedge funds, private-equity pools and venture capital firms. These deals aren't actively traded, so the product sponsors use a number of valuation alternatives to come up with reasonable estimates. Endowments must rely on these sponsor-produced estimates for reporting overall fund performance. But “until someone makes you an offer [for the illiquid asset], those valuations are never going to be completely accurate,” said Matt Cooper, managing director at Beacon Pointe Advisors, which manages about $4 billion, much of it from endowment and foundation clients. “If a [private-equity manager] is out raising money, he might be less conservative” with valuations, said Dan Lubek, managing director at Solis Capital Partners LLC, a private-equity firm. “If he wants to primarily maintain good relations with existing limited partners, he might be more conservative,” he said.

PRICING ISSUES

Data show that endowment funds have had problems with pricing real assets and private equity, said Christopher Geczy, an adjunct associate professor of finance at The Wharton School of the University of Pennsylvania and academic director of the Wharton Wealth Management Initiative.
“It is possible that this [illiquid] stuff has taken a bigger hit than [the endowment funds] think,” said Robert Whitelaw, a professor of finance at New York University's Leonard N. Stern School of Business. Longer-term returns aren't misstated, he said, but “stale prices make performance [numbers] sluggish.” Worse than some potentially stale valuations is the underestimating of risk among endowment funds, observers said. Researchers have found a high correlation of returns between different months for illiquid asset classes, which indicates that prices tend not to move as much as they should. As a result, volatility measures are being understated. “The estimates of the risk of those [endowment] portfolios [are] too low,” Mr. Geczy said. “Their Sharpe ratios [appear] high and their betas low — but that's not the case at all.” Mr. Geczy said his research on venture capital funds has found that estimated standard deviations in returns can be off by a factor of three. He is preparing a paper on statistical methods that can be used to adjust upward measures of volatility in illiquid investments. Such adjustments would make investments such as venture capital “a much less attractive asset class,” he said. Mr. Whitelaw said this smoothing of returns also makes it look as if alternative asset classes are less correlated with the stock markets than they really are. There is “unstated market risk” hidden within illiquid alternative assets, he said. Given the risks, Mr. Geczy wonders if endowments are demanding the returns they should be getting from their non-traditional assets. Investors should get about 50 basis points a year in excess return in exchange for a one-year lockup, he said, and as much as 3 percentage points for an investment that's locked up for 10 years. The endowment funds say they are getting that and more. In a report last month, Yale University said that over the 10-year period through June 30, its private-equity investments returned 24% per year, compared with a 1.2% loss from domestic stocks. At Harvard University, private equity earned an average of 15.5% per year over the same period, even factoring in a 32% loss in fiscal 2009, Jane Mendillo, chief executive of Harvard Management Co., said in a report last month. Alanna Kelleher, a Harvard spokeswoman, declined to comment, and Yale spokeswoman Gila Reinstein was not available for comment.

BASICS "STILL RIGHT'

Despite the valuation issues, those robust returns are why a long-term strategy of investing in risky, illiquid assets is appropriate for endowments, observers said. “The basics of the [endowment] model are still right,” even though endowments have suffered losses, said Mr. Geczy, who noted that people shouldn't be misled into thinking there is some magic formula the endowment funds are using that keeps individuals from replicating such high returns. “There are a whole slew of reasons why they can't get it,” he said, including the ability to accept the risks of illiquidity as well as getting access to top private-equity and hedge fund managers. E-mail Dan Jamieson at djamieson@investmentnews.com.