In the last 50 years, institutional investors have shifted their asset allocation significantly, with many reimagining the traditional 60/40 portfolio to include substantial exposure to private markets. Propelled by diversification benefits, a burgeoning array of private equity and venture capital opportunities, and the potential for enhanced returns relative to public market alternatives, Limited Partners (LPs) have increasingly expanded their allocations to private markets, with many assuming 10-30% (and sometimes more) portfolio allocations to private equity.
Several factors have contributed to LPs’ growing appetite for private market assets. Notably, the accommodative monetary policy post-GFC lowered long-term interest rates and expected returns across assets. To construct portfolios with a chance of meeting return targets, allocators had to embrace higher risk. As investors have sought to redesign their portfolio construction to include greater exposure to private markets, many have looked to two of the most successful allocators in the world — David Swensen and Dean Takahashi.
Historically, many institutional funds followed a conventional “60/40 portfolio” model (60% domestic equities and 40% bonds). When Swensen assumed control of Yale’s endowment, it was no different, with the majority invested in U.S. public equities, along with bonds and cash, resembling a typical mutual fund except for a minor real estate allocation.
Swensen, alongside long-time collaborator Dean Takahashi, took modern portfolio theory’s principle of diversification and pioneered an approach to endowment investing that transformed the institutional investment landscape. Largely known as the “Yale Model,” this approach emphasizes diversification and a risk-seeking orientation to capitalize on long-term investing horizons.
Unlike the traditional 60/40 portfolio, Swensen’s Yale Model sought to allocate less capital towards low-risk, low-return assets like fixed income and to deprioritize liquid assets. Instead, it pursued a greater allocation to private markets, which doubly benefit from their exposure to high-risk, high-return equity assets and illiquidity that generates greater expected returns.
These pioneering efforts yielded remarkable results. Over his 36-year tenure, Swensen transformed the Yale endowment from a modest, underperforming portfolio into one of the world’s largest and most successful endowments. When Swensen took over in 1985, the endowment was at $1.3 billion. With an annualized gain of 13.7% — outperforming the average endowment by 3.4% — his leadership grew the endowment to over $40 billion over 36 years.
Amid an investing landscape dominated by 60/40 stock and bond portfolios, Swensen’s approach sparked a revolution, with many endowments redirecting funds towards alternative investments over the past two decades. The Yale Model, now widely embraced by endowments, foundations, and high-net-worth individuals, is one of the most popular investment strategies employed by institutional investors.
Yet, the private markets, while offering the promise of substantial returns for LPs, aren’t devoid of challenges. Despite attempts by numerous institutional investment funds to emulate Swensen’s success, few have achieved comparable results. Many institutions encounter scenarios where they’ve tied up their capital for extended periods, paying hefty fees to managers who couldn’t beat the S&P, highlighting the distinct challenges that alternative investments present to a portfolio. From illiquidity constraints and managing cash flows against liabilities to manager selection, institutions pursuing greater exposure to private markets face several challenges.
Manager selection plays a pivotal role in private market investing due to the significant variation in returns among top and bottom-quartile private asset managers compared to their public counterparts. Unlike in public markets, where opportunities are defined by listings, private equity managers must actively seek out potential investments.
With limited access to comprehensive databases, fund managers rely heavily on their networks, research, and proactive outreach to source investments. Thus, the proficiency of managers in sourcing investments becomes a critical factor that can drive superior performance.
Numerous pension fund managers and institutional investors have endeavored to mimic Yale’s asset allocation strategy, only to discover that Swensen’s meticulous selection of managers was core to the endowments’ success. According to Yales’ own calculations, only 40% of its fund’s alpha is attributable to asset allocation, with the remaining 60% derived from superior managers.
Additionally, Yale’s skilled team and meticulous approach to sourcing blue-chip managers have undeniably played a substantial role in their endowments’ impressive returns. Further, the university’s influence and extensive network afford it access to top-performing funds that remain beyond the reach of numerous institutions.
LPs adopting a Yale-like model for asset allocation also face illiquidity and cash flow forecasting challenges. For one, balancing meeting capital calls with maximizing returns becomes a delicate task. LPs need to maintain sufficient cash reserves to prevent capital call defaults, but they must also avoid allocating excess capital to low-return, liquid assets, such as treasury bills.
However, forecasting capital calls is a nuanced process, as there is a great variation in timing and magnitude, influenced by factors like fund strategy, size, age, and available dry powder. For example, General Partners holding more dry powder typically make larger capital calls, and private debt funds tend to deploy more concentrated capital calls during the initial years of a fund than, say, venture or PE funds, which tend to follow a more gradual pace during the investment period.
Distribution profiles also vary widely. Private debt and real assets funds, for example, involve income-producing elements, generating returns faster than other strategies. Distributions are also sensitive to broader macroeconomic conditions. PitchBook research shows that during economic downturns, capital call rates remain relatively steady while distribution speed notably decelerates, reflecting a strategic inclination by General Partners to capitalize on discounted assets but refrain from selling positions at depressed prices. The current environment exemplifies this trend, with a stagnant exit landscape significantly reducing distributions and creating cash constraints for LPs.
This cash flow variability underscores the difficulty some LPs face aligning their investment timelines with their liabilities when dealing with private market assets and pursuing a Yale model of asset allocation. For example, insurance companies and pension funds require more accessible and predictable liquidity to pay out insurance claims and meet retiree obligations. In contrast, foundations and endowments invest with a perpetual mindset and can adopt more flexibility by sacrificing liquidity, increasing risk, and holding their assets for extended periods.
The chart below highlights this dynamic by comparing the top 10 university endowments against the top public pension plans. Private equity allocation is notably concentrated higher for universities. These two portfolio types have unique objectives, liabilities, and risk tolerance, among many other factors, highlighting that the Yale Model may be a strategy that should be used only by select fund allocators.
To address some of the cash flow forecasting challenges described above, David Swensen collaborated with Dean Takahashi and Seth Alexander to devise a cash flow forecasting model for illiquid alternative assets. This model, known as the Takahashi-Alexander Model, utilizes various inputs to project capital contributions, distributions, and net asset value (NAV) for a given quarter. Inputs include the rate of contribution, total capital commitment, fund lifespan, bow factor for distribution rate changes over time, annual growth rate, yield percentage, and paid-in capital.
The Takahashi Alexander Model is widely used by many LPs today to forecast the cash flows of their private market funds. However, given this model’s reliance on set assumptions, complementing forecasts with probabilistic components, such as Monte Carlo simulations, accounts for potential variability, providing a more holistic view.
This is part one in a three-part series exploring cash flow forecasting and allocation challenges for LPs. Check out the next article in this series to explore the evolution of private equity asset allocation in three distinct LP portfolios.
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