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How has the strategy performed? Swensen s investment philosophy is based on five principles. They are: 1. Equities outperform fixed income assets. According to him, not only do fixed income assets give lower returns but they are also affected by rising or highly fluctuating inflation. Exhibit 7 shows that for 2006, the returns for domestic as well as foreign equity were much higher that fixed income, which showed negative returns. Also, Swensen has referred to actual cumulative long-run returns of stocks vs. US treasury bonds and Treasury bills to demonstrate this. The 2006 returns and the 10yr annualized return structure of Yale has shown that this principle works indeed. 2. Hold a diversified portfolio mitigates risks. They tried to build the portfolio without attempting to time the market, rather by having strong disciplined approaches to investing. The inclusion of emerging markets in their foreign equities provides diversification, along with potential for high returns (due to the rapid growth in these markets). This aspect led the fund to generate good returns even during years of financial crisis. 3. Seek opportunities in less efficient markets which provide more opportunities for arbitrage. This is proved by the bigger spread in returns between the fund managers in the 25th and the 75th percentile. Although this area provides huge opportunities, it is difficult to provide meaningful benchmarks against which they could reliably measure the performance of managers and the success of their investment strategies in this area. 4. Use external managers for everything except the most routine of investments. This would ensure that the expert knowledge of capable managers is used to build Yale s investment decisions. However, choosing the managers is not an easy task, especially in the less efficient markets which lack any benchmarking system. And this in turn may jeopardize the investment decisions made. So this is deemed as one of the most important tasks undertaken by the Investments Office. 5. Focus on the incentives of the managers. Unlike current industry standards, Yale tried to align the incentives of the managers with their performance of the funds and not the size of the funds. However, if this is way of incentivizing the managers is an industry trend, then it will be difficult to pull managers into this kind of a structure. Overall, this philosophy is based on strong and clear fundamentals and hence stands the chance of providing great returns in the years to come. 2. How has the Investment Office selected, compensated, and controlled public market, real estate, oil-and-gas, and private equity fund managers? What explains the differences in their strategy? Are these differences disturbing? Public Market: The office eliminated passive portfolios and engaged small number of active equity managers. These managers were small independent organizations owned by their investment professionals. The office tried to select managers willing to coinvest and be compensated commensurate with their performance. Overall, the office was willing to give enough breadth to the fund managers in managing the portfolio. Real Estate: The office selected real estate operators who had a competitive advantage, either by property type or market, and a focus on an out-of-favor sector. The office sought partners who targeted distressed sellers, and those who had operating expertise to implement value-added strategies that could realize substantial returns over the medium term. The office wanted most of the real estate principal s compensation to come at the end of the fund and to be linked to the investor s returns. Although the office found such firms, they were not well-known, even by knowledgeable real-estate investors; this was a starkly different form Yale s PE funds. Oil and Gas: Yale focused on two different investment models: focus on partnerships in the business of acquiring existing oil-fields, and investing in partnerships pursuing PE investments in oil-and-gas and service companies.
Yale can partner with them for International PE ventures. And with the growth in emerging markets. Some venture groups formed affiliations with overseas groups. LBO firms have explicitly reduced their hurdle rates. Within the investment options available. and maintain a healthy mix of LBOs and venture capital funds. 4.Private Equity: For its PE investment. and earning all of its returns from the carry generated by the investment performance. as demand would be higher than supply. Yale feels that this would result in the PE groups in pursuing low-risk. Also. multi-billion dollar funds have become the norm. Also. Although Yale was willing to invest in a fund raising capital from institutional investors for the first time. Also that is the time when the markets become less efficient and increases chances of arbitrage. Some PE groups positioned themselves as asset managers. but Yale managed to identify some emerging market funds. It emphasized on organizations that took a value-added approach to investing as it felt that valueadded operational experience is more important in LBO investing. They generally invested heavily in markets when they were going through a change or turmoil. Along with that if they continue investing in quality funds. The new classes of investors entering the market. they have the chance of reaping good returns. All this affects the incentives of PE organizations as they lowered their return expectations and undertook safe investments. 2. when these institutions grow their expertise in international markets. The office was willing to give considerable latitude to firms to define the PE deals they wanted to do. The office also chose firms where incentives were properly aligned. Even they are highly competed. and many of these investments were made in an undisciplined manner. even this option had certain challenges. If Swensen wants to stick to Yale s basic investment philosophy. thus hindering the pursuit of innovative strategies. real estate. and private equity investments? What explains the differences in their strategy? Are these differences disturbing? The office had weighted their investments in less efficient markets. mostly based on the market conditions. which will be much less competed. However. Because that s when the office felt that the efficiency of sound investment principles would reap the best results. suggesting possibility of attractive valuations. with the heating up of the illiquid markets. Yale preferred the individual fund structure to be such that the PE firms could just cover the ongoing costs from the annual fees. there are opportunities of great deals in those areas waiting to be tapped. then the office may consider continuing to maintain its relation with the premier PE organizations. (b) deploying capital became increasingly challenging as there was intense demand for quality PE funds from the limited partners. it will be difficult to find suitable investments if demand increases. even if they are few and far between. there is an inherent underlying idea of properly aligning the incentives of the fund managers and the office. it will become more difficult to find god investment options. where far fewer firms were competing for deals. the international PE market was of growing interest. How has the Investment Office decided when to make public market. However. they always had a compelling category to invest in. The scale on which the PE groups operated. Although there are some differences in the strategies adopted in each investment category. This huge capital inflow had two significant consequences: (a) the influx of capital suggested intense price competition that would affect the PE industry in years to come. In such circumstances.low-return investments. that seemed attractive by normal standards. the office maintained long-term relationship with a few premier organizations. in order to ensure the ability to raise a follow-on fund. so as not lose the relationship with these premier organizations. Numerous overseas institutions and state pension funds invested heavily and in PE. With money flooded into the industry. 3. it makes sense to stay in the PE business. many of these situations carried large manager risks . and hence avoided those firms associated with larger organizations. oil-and gas. How is PE changing? What implications does this have for Yale? What should David Swensen do? The unprecedented growth of the PE industry appeared to have changed the industry in some permanent ways: 1. as the incentives of the larger financial institutions are not aligned with those of Yale. .
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