rises during a crisis, as declining liquidity and rising volatility increase bid-ask spreads and reduce trading volumes. The book notes that alternative investments have a very high liquidity risk, with private equity, venture capital, real estate, hedge funds, and infrastructure exhibiting liquidity betas in excess of 1.0. While these investments tend to have higher returns over long periods of time, the underperformance during times of crisis can be substantial due to the large exposure to liquidity risk. Chacko et al. also discuss liquidity-driven investing, an investment approach emphasizing the role of the liquidity of investments and the time horizon of the investor in the asset allocation decisions. Tier 1 assets are invested in short-term fixed income; tier 2 assets are invested in risky, liquid assets, such as stocks; and tier 3 assets are both risky and illiquid, such as investments in private equity and hedge funds. The endowment should estimate the spending and capital calls for the next 10 years and invest those assets exclusively in tier 1 and tier 2 assets, which can be liquidated quickly at relatively low cost. Tier 3 assets are designed as long-term investments; as such, the size of this allocation should be designed to prevent the need to liquidate these assets in the secondary market before maturity.
One measure of liquidity risk is the sum of the endowment's allocation to private equity and real estate partnerships combined with the potential capital calls from commitments to funds of more recent vintage. Bary (2009) reports, “At Harvard, investment commitments totaled $11 billion on June 30, 2008; at Yale, $8.7 billion, and Princeton, $6.1 billion. These commitments are especially large relative to shrunken endowments. Harvard's endowment could end this month in the $25 billion range; Yale's is about $17 billion, and Princeton's, $11 billion, after investment declines, yearly contributions to university budgets and new gifts from alumni and others.”
Takahashi and Alexander (2002) from the Yale University endowment office discuss the importance of understanding the capital call and distribution schedule of private equity and real estate investments. In these private investment vehicles, investors commit capital to a new fund, and that capital is contributed to the fund on an unknown schedule. A typical private equity or real estate fund will call committed capital over a three-year period, focus on investments for the next few years, and then distribute the proceeds from exited investments in years 7 to 12 of the partnership's life. Once an alternative investment program has matured, it may be possible for distributions from prior investments to fully fund capital commitments from new partnerships.
However, when starting a new program, it can be challenging to accurately target the allocation of contributed capital to these long-term partnerships. One rule of thumb is to commit to 50 % of the long-term exposure, such as a $10 million commitment once every three years to reach a long-term allocation of $20 million. Takahashi and Alexander offer specific estimates for the speed at which committed capital is drawn down for a variety of different fund types. Real estate funds may draw down uncalled capital at the fastest rate, with an estimate of 40 % of uncalled capital to be drawn each year. Venture capital is slower, with 25 % the first year, 33.3 % the second year, and 50 % of the remaining capital called in each subsequent year. Leveraged buyout funds may require a 25 % contribution in the first year, with 50 % of the remaining capital called in each subsequent year. Notice that not all committed capital is eventually called, so some investors may implement an overcommitment strategy by making capital commitments in excess of the targeted investment amount.
During the 2008 crisis, it became very difficult for managers to exit investments, as private equity funds could not float initial public offerings, and real estate funds could not sell properties. As a result, distributions were much slower than expected. When distributions slowed and capital calls continued, some endowments and foundations found it challenging to meet their commitments, as they had previously assumed that the pace of distributions would be sufficient to fund future capital calls. The price of a missed capital call can be steep (up to as much as a forfeiture of the prior contributed capital) and can result in being banned from participating in future funds offered by the general partner.
One feature of the endowment model is the minimal holdings of fixed income and cash. For example, going into 2008, Yale's target for fixed income was 4 %, with leverage creating an effective cash position of –4 %. Princeton had a combined weight of 4 %, and Harvard held approximately 8 %. Although income from dividends, bond interest, and distributions from private funds added to the available cash, in many cases the income, fixed income, and cash holdings were not sufficient to meet the current year's need for cash. With a 5 % spending rate, it became necessary for these endowment funds to either borrow cash or sell assets at fire-sale prices in order to guarantee the university sufficient income to fund its operations. To the extent that the endowment also had capital calls for private equity and real estate funds, the need for immediate cash was even greater. In some cases, the universities cut spending, halting building programs and even eliminating some faculty and staff positions, while raising tuition at higher rates than in prior years.
When cash is scarce, it can be difficult to have such large allocations to illiquid alternative investments and such small allocations to cash and fixed income. Sheikh and Sun (2012) explain that the cash and fixed-income holdings of an endowment should be at least 6 % to 14 % of assets to avoid liquidity crises in 95 % of market conditions. To completely eliminate liquidity risk, cash and fixed-income holdings may need to be as high as 35 %, far above the allocations that most endowments are comfortable making, given their high expected return targets. By drawing down this cash cushion, the endowment can continue to fund spending to support the university budget while avoiding a liquidity crisis that would lead to the distressed sale of assets at the low point in the market or an emergency increase in the debt burden. Greater cash holdings are necessary for universities with larger outstanding commitments to private equity and real estate funds, greater leverage, higher spending rates, more frequent rebalancing, or larger allocations to less liquid assets.
To avoid liquidity crises, Siegel (2008) suggests laddering allocations to private equity and real estate funds, ideally at a schedule in which distributions from maturing funds are sufficient to fund capital calls of partnerships of more recent vintages. When adding real estate and private equity partnerships to the portfolio, investors are encouraged to spread the new commitments over multiple years rather than making a large initial commitment in a single vintage year. In addition to spreading capital commitments over time, Siegel suggests that liquidity can be improved by growing the gift income of the endowment, borrowing, or reducing the allocation to less liquid alternative investments. Private equity and real estate partnerships are less liquid investments, while commodity futures funds and hedge funds with lockups of one year or less are more liquid alternative investments.
Leverage can also create liquidity issues. Short-term leverage, such as that provided by prime brokers to hedge funds, may not be sustainable or affordable during times of crisis. When credit lines are reduced or not renewed, investors may have to repay loans on short notice, which can require the sale of investments at very low prices. Many fixed-income arbitrage and convertible bond arbitrage funds suffered significant losses during the most recent crisis, as a reduction in leverage from eight times to four times required the immediate sale of half of the portfolio. When the market knows that these sales are coming, and a number of hedge funds are simultaneously forced to sell due to credit line reductions as well as investor redemptions, liquidity risk is extreme as buyers of these fixed-income assets wait to purchase until the prices of the convertible and mortgage-backed bonds have fallen precipitously. Endowments and foundations that invest in leveraged hedge funds must be prepared for the potentially large drawdowns in these strategies, as well as the potential for the erection of gates that prevent investors from redeeming their assets from hedge funds during times of market crisis.
The liquidity crisis of 2008 brought criticism to the endowment model. Williamson (2011) quotes Daniel Wallick, principal of Vanguard's Investment Strategy Group, as saying that the endowment world's pre-2008 blind emulation of the Yale approach has passed. Endowments and foundations today need to focus on having greater access to liquidity in their funds, which may lead both to declines in the commitments toward future private equity and real estate funds, and to increases in the cash and fixed-income allocations.
