Endowments: Still gold standard?

Buried deep in Menlo Park, sharing a road with SRI International, the contract research operation spun out from Stanford University and, a few blocks from the northern end of VC hotspot Sand Hill Road, is the office of Foundation Capital. Set up 18 years ago by a group of entrepreneurs, the California venture capital firm now has more than $2.4 billion under management and backs start-ups in industries ranging from cleantech to consumer internet.

Foundation is also seen as a classic example of endowment clustering. While the LP base now includes pension funds, foundations and fund-of-funds, industry participants say that a small group of endowments were there from the beginning, effectively seeding the operation, and continue to feature prominently.

Endowments' reputation for identifying the leading edge fund managers before everyone else was built upon their experiences in US venture capital. They figured strongly from the 1980s, in the early days of the asset class, and remain its backbone. The power of the cluster effect is that once you bag one endowment, you are likely to get interest from several more, and then other institutions start to take notice.

"They socialize, talk to each other, work for each other at different points - there is a certain tightness to these clusters," says Mounir Guen, CEO of MVision. "They have contact but they don't always listen to each other. We inform them of who we are representing; one endowment might get excited about a fund and call up 2-3 others, and maybe they'll come on board."

This perceived expertise in cultivating new managers has afforded the endowments a disproportionate influence on fundraising in Asia as well, as a number of GPs can attest. "They are seen as leaders and will attract other investors by virtue of their status in the market," says Tom Lembong, co-founder and managing partner of Quvat Management, an Indonesian GP with endowments among its LPs.

Crisis mode

In 2009, however, the wheels fell off. Over the course of 12 months, there was a 23.2% drop in the market value of 864 North American endowments tracked by the National Association of College and University Business Officers and CommonFund. The five largest players - Harvard, Yale, Stanford, Princeton and University of Texas - accounted for more than $109 billion in assets in 2008, but only $79 billion a year later. Harvard alone saw its value plummet 29.8% to $25.6 billion, although a strong 2012 might see it finally wipe out these losses.

Endowments are noticeably less conspicuous in the market than before. Although they haven't retreated from the asset class, allocations don't come easily and it begs the question whether the traditional high risk-high return strategy can be sustained. Do these institutions still have - or want to have - the X factor?

"It's smart money and it's good to get them because they are long-term investors," one pan-Asian GP tells AVCJ. "But in 2008-2009, they were the hardest hit and had the biggest liquidity problems. Suddenly they were not the smart money - they were swimming naked and trying to get out of their commitments. A lot of the things that made them outstanding are no longer true."

It could be argued that a relatively higher exposure to private equity - and, within that, to higher risk venture capital practitioners - exacerbated the endowments' post-global financial crisis struggles compared to their institutional counterparts. Indeed, liquidity remains a pressing issue: even if mark-to-market returns are healthy, actual cash coming back is a fraction of what it used to be.

Yet the reasons for the endowments' current reticence are more complicated. Firstly, they depend on voluntary donations not monthly contributions so it takes them longer to renew their capital reserves than pension funds. Secondly, some claim that the growing needs of the educational and charitable endeavors that endowments support have also curtailed activity.

All North American LPs have become pickier about their allocations in recent years, cutting the overall number of fund manager relationships and prioritizing protection of capital over stellar returns. According to Sanjay R. Mansukhani, senior manager research consultant with Towers Watson Investment Services in New York, endowments are following this pattern to the extent of rationalizing portfolios and backing managers who have delivered for them in the past. But they are also becoming more opportunistic.

"Rather than having a bucket marked ‘private equity', they now regard private markets more holistically and are looking for opportunities in natural resources, real estate and infrastructure as well," he says. "They want to be able to take advantage of opportunities when they present themselves."

Not everyone can be Harvard, Stanford or Yale. Preqin tracks 473 North American endowments and less than 15% of them are able to commit more than $250 million to the asset class. Mansukhani adds that the broadening of the investment landscape has seen an increasing number of endowments turn away from a common approach in favor of strategies that meet their individual needs.

Picking winners

At the same time, average private equity allocations among the endowments covered by Preqin have been above 10% of total assets since 2009 and are expected to reach 13.2% this year. The average among public pension funds is 6.8%. Given the capital pressures, the potential costs of investment strategies coming up short are significant. Careful selection is therefore paramount, and industry participants argue that endowments retain their expertise in this area.

Gary Rieschel, founder and managing partner, Qiming Venture Partners, sees experience as a key differentiating factor between endowments and other institutional investors. While there is inevitably a degree of staff turnover - investment officers tend to move between endowments, which actually contributes to the clustering effect - personnel has remained consistent at senior level.

"Team stability at the top endowments tends to be very good," says Rieschel. "If you look at fund-of-funds and pension funds you see a lot of turnover, but at the six largest endowments investing in Qiming, the CIO hasn't changed in six years. That gives them more institutional knowledge about what is happening."

This experience contributes to a nuanced approach to GP assessment. Endowments' are said to carry out detailed due diligence and have long memories. At the same time, they have strong pattern recognition systems in terms of what constitutes a successful VC firm.

In this sense, the contrast between the endowment and pension fund approach to entering and then participating in a fund is instructive. On a basic level, pension funds work to 75-year horizons, put substantial amounts of capital to work and are looking to outperform public markets. Endowments typically make smaller, riskier investments and are more short-term sensitive. They aren't tied to focusing on certain geographies, so the first consideration is often currency risk, after which attention turns to the returns and safety of capital.

"A lot of institutions have a very bureaucratic process for making decisions but once they make the investment they are quite hands-off. Endowments are minimally bureaucratic but incredibly astute and remain quite hands-on" says Quvat's Lembong.

At the same time, there is an objective, almost academic, approach to performance assessment. Often how a GP addresses a problem - Does a manager write off a portfolio company and walk away, or try and fix it? - is considered more important than what happens in the end. Again, this approach could be seen as typical of investors that come from a VC background. A GP that backs early-stage companies is betting on the abilities of the entrepreneur as much as on the business plan. Endowments judge GP management teams in a similar fashion.

"They want to know if you can learn from your mistakes, and this is where character, personality and values come in," says Lembong.

Rieschel adds that endowments place great emphasis on team stability. All prospective LPs ask about sector strategy and want to know about a GP's portfolio and meet the CEOs, but the most pointed discussions Qiming has with endowments concern compensation structure - junior employees must be suitably incentivized to stay with the firm - and self-assessment.

"I have friends who run some of the large funds and they will say that where the money comes from doesn't matter," says Rieschel. "It's probably true for the large funds but that's not the case for early-stage players. We have a 6-9 year holding period and the LPs need to be thinking about that timeframe. It might be 10-12 years before you get the cash back."

Appetite for Asia

The Preqin study found that nearly three-quarters of participants believe their domestic markets offer the most attractive private equity opportunities. Only 25% singled out Asia. However, 90% of endowments already invest in emerging markets or are considering doing so - compared to 76% in the wider LP universe - and Asia is by some distance the most tempting prospect. China is the preferred country, comfortably ahead of India, Russia and Brazil.

The endowments' entry into China was eased by the presence of funds affiliated to US venture capital firms that they already backed. Sequoia Capital seeded Sequoia China; in moving from indirect to direct exposure to the fund, endowments knew what they were getting.

This wasn't the case in India and Indonesia, where accessing local GPs is just as important as in China, but there were no affiliates to light the way. Endowments were ahead of the field when it came to institutional exposure to these countries and their backing lent much-needed credibility to the GPs in question. Interestingly, the two PE firms were run by Harvard alumni.

"When we got Harvard as an anchor investor in 2001, it was crucial because it signaled to other institutional investors that we were the platform in India," Ashish Dhawan, co-founder of ChrysCapital Partners. "We ended up with Stanford in the same fund."

Securing Harvard's support, however, wasn't straightforward. Dhawan received seed capital from several former colleagues at Goldman Sachs plus contacts he'd developed at Harvard Business School (HBS) rather than from the endowment itself. Jay Light, one of Dhawan's HBS professors, was chair of the investment committee and although this got ChrysCapital a meeting, the endowment refused to back a first-time fund. It ended up participating in Fund II, which at $127 million was more than twice the size of its predecessor.

Quvat, which marked several US endowments' first foray into Indonesia, is a similar story. Lembong admits that attending Harvard "might have helped a bit," but the impact was more nuanced than simply tapping the old-boy network. Harvard got involved once Quvat was on its second fund and could point to the makings of a track record, but even then its participation came following a referral by Stanford. This initial endorsement brought in one other endowment and helped when signing up further LPs.

Where Lembong's Ivy League roots might have come into play - and they would by no means have been the only factor - is in making the endowments feel comfortable: He talks the way they talk and thinks the way they think.

This applies to many GP-LP relationships. Institutional investors have certain expectations in terms of terms, fund structure and compliance, but beyond that they need to be convinced by the investment thesis and the management team's ability to deliver on it. In the emerging markets, an individual with a US accent, a US education and a grasp of US business conventions and formalities might well strike more of a chord with a potential investor than someone from a different background.

In the case of endowments, MVision's Guen takes it a step further. "Whenever a certain Ivy League-trained person speaks, I can tell you the formula and more or less how many words they will use," he says. "They will recognize a dean, quote a recent luminary, quote some archaic historical figure, thank a few professors, say something personal, and tell three jokes."

The magic touch, localized

The long-term issue is whether this approach will enable endowments to retain their edge in an increasingly diversified LP landscape. Most North American LPs are still only on the cusp of Asia: pension funds have traditionally entered the region through pan-regional funds while endowments and foundations have largely relied on their own networks, such as the VC or alumni communities.

Penetrating more deeply into the region means leaving the comfort zone and identifying managers whose personal qualities or strategies are well suited to their own markets but alien to the endowments. For example, ChrysCapital's Dhawan spent a long time convincing Harvard that PIPE deals were a viable investment strategy in India and regards it as turning point for the firm.

There is recognition among the endowments that they must be more diversified - or, as one GP puts it, "stop coming across as so overwhelmingly Caucasian and male." Asia specialists, who are in some cases of Asian origin, increasingly appear in the ranks of investment teams and Harvard is said to be considering a permanent base in the region. It recently deployed one of its senior private equity executives to Shanghai for about a year in order to get an on-the-ground perspective.

"They have begun to take trips to emerging markets in different parts of the world. They recognize that they might not have the appropriate expertise, so they are committing resources in house or outsourcing to advisors," says Towers Watson's Mansukhani. "They know that if they are going to do it seriously they must be able to go beyond the most sought-after names."

SIDEBAR: Size matters - Endowments seek smaller funds

North American endowments are the pioneers of the private equity world in that they have a reputation for uncovering managers able to deliver strong returns. But they can leave just as quickly as they arrive.

While a $200 million fund might be capable of a 3x return, if its successor vehicle comes in at four times the size due to heavy demand from investors then the past performance is harder to replicate. Industry participants warn that an endowment is unlikely to favor a $1 billion China vehicle.

"They have been sensitive on fund sizes and gone for smaller funds where they can put more capital to work and feel comfortable," says Mounir Guen, CEO of MVision.

Like most LPs, endowments are consolidating their private equity commitments, sticking with managers with good track records and raising the bar for new GPs. They are also going smaller. According to Preqin's recent study of North American endowments as investors in PE, more than one third of participants are seeking to invest in small to mid-market buyout funds in the next 12 months. Distressed assets and fund-of-funds are the second most popular category, with large to mega buyouts and venture trailing in single digits.

Gary Rieschel, founder and managing partner of Qiming Venture Partners, says that endowments interested in backing venture capital are also dismissing larger players in favor of $50-100 million early-stage funds. Specialization is another valued quality - GPs who pursue the latest market trends are not in vogue.

"The risk profile for these funds is better than for those that put money into Facebook at $55 billion pre-IPO," says Rieschel. "The risk profile is also changing in China and other emerging markets. The endowments are looking for firms that are focused in certain areas and can offer something they can't get somewhere else."

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• Topics
• LPs
• North America
• Greater China
• South Asia
• Southeast Asia
• LPs
• USA
• Asia
• China
• India
• Indonesia
• ChrysCapital Management
• Qiming Venture Partners
• Quvat Management
• Endowments