In recent decades, sophisticated institutional investors, including many leading higher education endowments and foundations, have shifted their asset allocation toward private markets in search of higher returns and increased diversification.
Perhaps the most well-known and successful private equity proponent was David Swensen, who managed Yale University’s endowment for over three decades.
When Swensen took the helm at Yale in 1985, about 65 percent of the portfolio was allocated to U.S. equities, 15 percent to U.S. bonds, and none to private equity. Today, U.S. equities, bonds, and cash represent less than 10 percent of the endowment’s target asset allocation.
Largely by turning to private markets, Yale reported total returns during Swensen’s tenure in excess of returns produced by traditional 60/40 stock and bond portfolios.* But Swensen himself recognized the difficulty most investors experience in executing a successful private equity strategy. In his landmark book, Pioneering Portfolio Management, he wrote: “While illiquid markets provide a much greater range of mispriced assets, private investors fare little better than their marketable security counterparts as the extraordinary fee burden typical of private equity funds almost guarantees delivery of disappointing risk-adjusted results.”
The Challenges of Private Equity Investing
Beyond the high fees Swensen noted, there are other significant challenges to investing in traditional private equity funds. These include issues related to:
- Liquidity: Private equity investments are illiquid, and limited partners do not control when their investment dollars will be called, when they will receive distributions, or when their limited partnerships will end.
- Diversification: It often takes years and intense effort to build a diversified private equity portfolio fund by fund.
- J Curve: Limited partner returns are negative in the initial investment years due to fees since general partners require capital commitments years prior to any capital calls or distributions.
- Duration: Private equity funds today may last 12 to 15 years or more due to so-called “zombie” or stranded fund investments.
- Cash Flow Timing: Limited partners do not know when their capital will be called, and the timing may not be in the best interest of the investor.
Traditional private equity fund investors may also suffer untimely and unreliable performance reporting due to lack of uniform standards for each. In addition, private equity discussions tend to absorb a significant amount of an endowment committee’s time.
A Potentially Better Solution: Evergreen Funds
Our research team has concluded that so-called evergreen funds may offer higher education investors a better solution for accessing private equity. Evergreen funds are structured as closed-end funds that utilize profits from company exits to invest in new opportunities rather than distributing them, thereby creating an “evergreen” lifespan.
Due to their distinctive structure, evergreen funds help address many of the issues that make traditional private equity funds less attractive. Of greatest importance, the fees are generally less than half those of traditional funds, and investments in the funds provide for periodic liquidity, albeit with some restrictions. This may include penalties if an investor sells some or all their holdings within the first year of an investment or the evergreen fund manager restricts how much of the total fund can be liquidated at any given time. Most evergreen offerings also provide broad and immediate diversification, typically allocating assets across several hundred companies through primary and secondary offerings and co-investments. Diversification is also achieved through the inclusion of multiple vintage years, sectors, and geographies.
Investors in evergreen funds can benefit from fund returns on day one, potentially avoiding the early year negative returns related to the J curve. And since there are no capital commitments or capital calls, investors can retake control of the amount and timing of cash flows into and out of the funds.
Leading private equity firms offer several attractive evergreen funds to higher education foundations and endowments. Since the structure, performance, and fees of these funds can vary significantly, careful due diligence is critical to selecting the fund that best meets each foundation’s or endowment’s specific needs and requirements. It is also important to consider the fund in the context of an educational institution’s overall portfolio to weigh how the fund will contribute to performance and risk management.
For many institutions, accessing private markets may offer significant advantages in enhancing portfolio returns and managing risk. However, to fully benefit from the added value of private equity, it might be beneficial to utilize investment vehicles that overcome some of the barriers to traditional private market investing. At Mason, we believe considering evergreen funds may be an attractive option.
For more information about Mason’s institutional services and our approach to private equity investing and portfolio construction, visit masoncompanies.com/services/institutions.
* “‘Self-confident yet selfless’: Yale’s David Swensen dies at 67,” YaleNews, May 6, 2021.
The views, opinions and content presented are for informational purposes only and reflect the current opinion of the writers as of September 30, 2023. Opinions and forward-looking statements expressed are subject to change without notice. The content presented does not constitute investment advice, should not be used as the basis for any investment decision, and does not purport to provide any legal, tax, or accounting advice. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete, and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Thomas Pudner is co-chief investment officer and co-director of research, and Jason Doyle is associate consultant and co-director of research at Mason Investment Advisory Services, Inc.
Opinions expressed in AGB blogs are those of the authors and not necessarily those of the institutions that employ them or of AGB.