Gregory J. Muth MPA, MS Hedge Funds, Private Equity, and Leveraged Buyouts – Unlocking the Mystery of Wall Street: Financial Literacy for Non-Profits

Let’s Talk About… Alternative Assets for investment: Hedge Funds Private Equity Buy-out Funds, including leveraged-buyouts Investment Strategies – old and new 60 / 40 Rule Modern Portfolio Theory Value at Risk – Extreme Value Theory Investment Returns The Yale Model The Breakdown – What Happened? If You Have Assets to Invest, You Should Have an Investment Policy

Investment Strategies – old and new 60 / 40 Investment Rule Long / Short Non-directional Equity Modern Portfolio Theory Value at Risk – Extreme Value Theory

Investment Returns What is Total Return? Why do we Benchmark? What you should know: All rates of return should be based on “market values” Calculating a “rate of return” is simply a matter of applying the right arithmetic; Deterring whether a fund’s rate of return is good or not is harder. Need to use benchmarks, analysis and judgment

The Yale Model Relying heavily on modern portfolio theory, Swensen and Yale endowment managers developed the following five principles, which have become the basis of the Yale Model: Invest in equities, because it is better to be an owner rather than a lender. Hold a diversified portfolio, avoid market timing, and fine-tune allocations at extreme valuations. Invest in private markets that have incomplete information and illiquidity to increase long-term incremental returns. Use outside managers except for all but the most routine or indexed investments. Allocate capital to investment firms owned and managed by the people actually doing the investing to reduce conflicts of interest.

Financial Crisis of 2009 EndowmentHedge Funds Domestic Equity BondsForeign Equity Private Equity Real AssetsCash Harvard18%11% 22%13%26%-3% Yale25%10%4%15%20%29%-4% Princeton24%7%2%12%29%23%2% Stanford18%37%10%N/A12%23%N/A Average Education Endowment 22% 12%20%9%14%2% Average Asset Class Return for the Period -20%-27%6%-31%-50%-47%2%

The Breakdown – What Happened? Fundamental illiquidity – universities were keeping little of their money in cash Median decline in return for all endowments in fiscal 2008 was 19% For the same period, the S & P 500 declined 26.2% Large Ivy League endowments fared worse It got so bad that universities were forced to borrow

How Bad Was It for Ivy Endowments?

Extreme Events in Investment History Black Monday (1987) The Gulf War (1990) The Mexican Crisis (1994) widely known as the Mexican peso crisis or the Tequila crisis, was caused by the sudden devaluation of the Mexican peso in December 1994devaluationMexican peso The Asian Crisis (1997) a period of financial crisis that gripped much of Asia beginning in July 1997, and raised fears of a worldwide economic meltdown due to financial contagionfinancial crisisAsiafinancial contagion The Tech Bubble (2000) aka the dot com bubble 9/11 Terror Attack (2001) The Credit Crisis (2008) the threat of total collapse of large financial institutions, the bailout of banks by national governments, and downturns in stock markets around the world. In many areas, the housing market also suffered, resulting in evictions, foreclosures and prolonged unemployment.bailoutevictionsforeclosures

Lessons Learned by Harvard “On the topic of limited partnerships, we also intend to continue to reduce uncalled capital commitments to real estate and private equity fund managers. Our uncalled capital commitments at the end of fiscal year 2010, were $6.6 billion, down from over $11 billion two years ago.” “We have attended closely over the last two years to liquidity [emphasis added], capital commitments and risk management….” “We also need to be mindful that our portfolio, while large, still operates under liquidity constraints [emphasis added] and spending demands that are greater than they were 5-10 years ago. The endowment now funds 35% of the total University budget.” “Can our strategies and insights be improved? Yes. We learned some specific lessons over the last two years about keeping control of our capital and being prepared for unexpected market conditions.”

Lessons Learned by Yale “Prudent investors maintain sufficient liquidity to meet the full range of portfolio commitments, which, in the case of an endowment fund, include annual spending distributions and contractual commitments to external money managers.” “Even with a zero allocation to cash in the portfolio, investment holdings generate a fair amount of natural liquidity. For instance, bonds pay interest, stocks pay dividends, real estate produces rents, energy reserves provide returns on capital as well as returns of capital (through depletion), and private equity partnerships distribute proceeds from realizations.” “Liquidity matters, even to portfolios with modest spending requirements and long-term horizons. By putting in place mechanisms to tap a variety of internal and external sources of liquidity, endowment managers provide the means for educational institutions to satisfy the full range of portfolio commitments.”

Lessons Learned for All Modern portfolio theory and asset allocation are not dead. Alternatives can and do play an important role in a well-constructed and well- diversified portfolio. The difficulties of the large endowments don’t reflect a breakdown of the principles of asset allocation; rather, they reflect failure of endowment managers to properly diversify and plan for extreme events. Endowments must model and prepare for extreme events, evaluate whether the classification of their assets genuinely reflects true diversification, and perhaps most importantly, appropriate a much larger portion of their portfolios to cash and other liquid assets.

So Now What? Investment Policy – Key Elements A basic investment policy: Identifies the assets available for investing; Defines general investment objectives; Sets asset allocation parameters (e.g. diversification); Clarifies the organization’s tolerance for risk (does this by defining required rating)

Thank You Hedge Funds, Private Equity, and Leveraged Buyouts – Unlocking the Mystery of Wall Street: Financial Literacy for Non-Profits Gregory J. Muth MPA, MS