the Yale model
I spent six years during the 1970s at Yale getting a PhD in European philosophy, before stumbling into the stock market in 1978. So I was particularly interested when in 1985 the university, which had had a checkered record managing its endowment, hired David Swensen, a Yale economics PhD who had spent a few years doing esoteric bond transactions on Wall Street, to take the endowment reins.
Swensen’s basic idea was a kind of arbitrage. He knew that a university typically didn’t need day-to-day, or even year-to-year, liquidity in its investments. So it made no sense to pay a premium price, or even the market price, to acquire liquid investments like publicly traded stocks and bonds. Better to look for virtually identical investments that one could buy at, say, a 25% discount to what a similar, publicly traded equivalent might sell for–in return for committing to maybe a ten-year holding period.
Two characteristics of this approach that would be worrying for a mutual fund are: the lack of a daily price determined by a neutral third party like Mr. Market; and the time and effort involved in eventually selling a position. But not a big deal for an endowment. Besides this, in the early days Yale pretty much had the field to itself, so it could be very picky in what it bought.
public pensions
Swensen’s success over the years spawned imitators, initially among other endowments, but also, somewhat more recently, among traditional pension funds. I suspect that for the latter group, mostly public employee pension funds, private equity was especially attractive, given that many are chronically underfunded. Two reasons: the presumed higher returns, and the absence of a daily mark to market. Why is this so key? My thought is that public employee pension funds tend to be underfunded and that legislatures are not eager to use tax receipts to make up the shortfalls. Hence, the willingness to up the risk profile of the portfolio holdings.
private assets now increasingly for sale, however
Two reasons. I think:
–more pension/endowment market buyers for private assets has meant less of a premium for taking the liquidity risk, and, probably more important,
–the Trump tariff plans seem to me to have lowered the value of any US-centric corporate assets, and especially ones that use foreign inputs. Just look at the plunge in the dollar since the inauguration. The performative cruelty of his Hitleresque use of ICE can’t be helping, either.
It’s hard to know how this will all play out. My guess, though, is that we’re nearer to to the beginning of selling pressure than the end.
Thank you Dan. “Nearer to the beginning of selling pressure…” is uncharacteristically negative for you; however, I suspect you are right for all the reasons you’ve stated as well as the decades of debt accumulation in our economy and other major economies around the world (the Ray Dalio thesis).
Hi Chris! Hope you’re doing well. The really bad case would be if problems with private equity spilled over into other parts of the financial markets. In the case of junk bonds, for example, individual issues were highly illiquid yet were held in specialized mutual funds sold to retail investors. The sales pitch was: all the returns of stocks with all the safety of bonds. What no one mentioned was how illiquid junk bonds were or that they were carried on the mutual fund books at issue price, no matter what the fundamentals. Or that Michael Milken was offering monetary rewards to PMs who blindly bought each issue. Once a retail panic developed, the lack of buyers became an insurmountable issue. Because the key parties here are all institutions, my guess is that they will more or less quietly take their lumps. The much bigger worry, I think, is the one you point out, along with the waning credibility of the US.