The Times They Are A-Changin’

During an overall great run for financial assets in recent years, the Endowment and Foundation community – by almost all measures – exceeded expectations. All told, our recent survey of top E&F CIOs revealed that, through a combination of strong performance and increased inflows, many of these organizations are now overseeing two times (or more) the assets under management that they did just a few years ago. This growth is great news for the important causes that the endowment and foundation community support. However, if these entities are to maintain the superior investment performance their boards desire and constituents need, especially given their new heft and scale, we believe that CIOs will need to consider a new approach, including a potential overhaul of their business footprint. This need for change is occurring at a unique moment, as we are now entering a potential macroeconomic and geopolitical regime change that likely warrants a new approach to asset allocation, including shorter duration and greater exposure to Real Assets, we believe. We also see a greater need for these organizations to consider placing a more holistic emphasis on portfolio construction, technological prowess, and risk management. Importantly, in recent years earlier stage, higher Beta, longer duration equity investments led to much of the outsized asset growth in the E&F community; however, it now feels to us that the E&F community is over allocated to this area at a time when both performance and realizations are poised to slow. So, this positioning could prove tricky, as we enter an environment where the traditional relationship between stocks and bonds, and in particular growth stocks, has changed. To this end, now is the time for all of us with ties to the E&F community to take a step back and recognize that, ‘the times they are a-changin’.

As the son of a life-long educator who was committed to expanding access to top tier education for all types of students irrespective of financial resources – I have seen how foundations and endowments work to expand opportunity and create greater mobility across our society. Moreover, a deeper understanding of what an incremental dollar of return could do to improve a person’s trajectory in life has certainly shaped the way I think about asset allocation, risk management, and portfolio construction today. Over the past three decades, I have also had the good fortune to serve on many leading endowment and foundation boards and investment committees as well as to learn from some of the best and brightest CIOs in this segment of the business.

So, after years of informal conversations with many of my peers in the endowment and foundation community, I recently decided to tap into our E&F clients and prospects to formally learn more about how they are approaching their jobs in today’s complicated macroeconomic environment. All told, we surveyed more than 30 CIOs of endowments and foundations representing hundreds of billions in assets under management as well as conducted many calls, zooms, and face to face meetings with some of the industry’s leading thinkers to drill down on key issues.

EXHIBIT 1

Our Survey Participants Were Mainly from the Endowment Community

What did we learn along the way? Well, as Bob Dylan famously sang, ‘the times they are a-changin’. See below for full details, but we note the following:

1. Strong performance and increased inflows have led to substantial asset growth in recent years. More investment ‘infrastructure’ is likely required to sustain this new base, we believe. Many organizations with whom we spoke are now overseeing at least two times more in assets under management (AUM) than they did just a few years ago. Not surprisingly, this growth is straining the system, including investment staff, IT, and various support functions. While 70% of our respondents indicated that they did not need to add more personnel or to make other changes, we respectfully would disagree. Specifically, we think there is a need to add staff to accommodate the significant increase in AUM, in particular staff with deeper product knowledge of new areas of finance, greater specialization across asset classes, and experience growing co-investment programs. Overall, we see the need to move to a more top-down emphasis on portfolio construction/asset allocation. At the same time, we fully acknowledge that there is now greater scrutiny of the average E&F organization, including of rising compensation levels as well as alignment to mission (i.e., should endowments pay taxes if payout ratios are going down towards zero as at some of the larger plans?) In our humble opinion, the status quo is actually leading to slower than expected growth in staff, which we view as an increasing long-term risk for the industry. As a stop-gap measure, many CIOs are consolidating relationships and concentrating their assets with some of their best managers. We support these efficiency gains. Ultimately, though, we believe that gains in AUM require more scaling of headcount if organizations are to retain superior investment performance, particularly at the large plan level, as well as cover new asset classes.
2. Higher Beta, more growth-oriented investments, have carried performance and led to outsized asset growth in recent years. However, it now feels to us that the E&F community is over-allocated to this area at a time of falling expected future returns. Of all the groups with whom we interact, we think that E&F managers likely allocated the most to VC, Growth, and high-Beta Public Equities during the post-COVID run-up. For some, there is definitely a bit of buyer’s remorse, as – unfortunately – many GPs in these areas called a lot of capital during the peak run-up in 2021, and there is a ‘hangover’ effect that many endowments and foundations are now feeling. This is exacerbated by the fact that, when markets sell off these days, both stocks, especially growth stocks, and bonds go down together. This portfolio construction headwind is consistent with our KKR regime change thesis. (For a more detailed discussion see Walk, Don’t Run: Mid-Year Update 2022 and Regime Change: Enhancing the ‘Traditional’ Portfolio). There is also the reality that the dramatic slowdown in realizations from many of these investments is now front and center with both CIOs and their boards, particularly given how many non-profits have started to issue bonds that are rated by agencies for their cash flow generation prowess. The lack of capital being returned is also adversely affecting CIOs’ ability to reposition their portfolios in many instances. Finally, our research shows that only a select group of E&F managers are typically getting access to the best managers at the right time in the cycle. This somewhat subtle reality, which calls into question whether VC is a scalable asset, is leading to sub-optimal outcomes: our work shows (see Exhibits 31 and 32) that only the top handful of VC managers outperform so meaningfully that the increase in volatility is warranted.
3. After the recent downturn in Equities, many CIOs want their GPs to ‘stay in their lanes’. Indeed, one clear conclusion from our study is that CIOs felt somewhat blindsided of late by long/short hedge funds that ended up with not only weak performance but also sizeable illiquid positions that can’t be redeemed for the foreseeable future. At the same time, there were several Venture Capital managers that held on too long to their public positions after 2021’s IPO bonanza. The net result, we believe, is that CIOs will increasingly migrate towards managers who, as one CIO put it, “stay in their lanes so we know how to better measure our liquidity and volatility metrics, particularly in choppy markets.”
4. CIOs acknowledged that much of their excess performance in recent years has come from astute manager selection. By comparison, asset allocation has added little to no value during this period. We think this ‘mismatch’ of alpha generation may need to change on a go-forward basis. Many CIOs tell us that recent attribution trends make sense, given their heavy focus on bottom-up manager selection as a long-term, core competency. Importantly, however, we think that, as organizations scale in this space, CIOs should consider adding more top-down guard rails to ensure that their teams are sizing positions properly, creating the right sector and thematic tilts, and tightening up risk management practices, including factor analyses (i.e., what bets have you really made with the portfolio?) Boards may not like the additional infrastructure costs, but we believe that the next generation of successful E&F offices will need this tool in the toolkit to retain their pre-eminence, as the competitive landscape becomes more intense. Already, we are seeing large family offices bulking up their resources in an attempt to gain mindshare and wallet share, including adding more co-investments with GPs in a post-pandemic world.
5. Despite having already extended portfolio duration by owning more investments that are not likely to be realized in the near-term (either through lack of realizations or through rolling quality assets into continuation funds), CIOs want to increase their exposure to illiquid investments even further. In fact, today the average CIO holds 52% in illiquid-type investments compared to 48% before COVID. Many continue to own hedge funds (average hedge fund allocation is 15% in our survey), but the mix shift is clearly away from long/short and more towards diversifiers, including absolute return funds. We do, however, want to acknowledge that our group of respondents is – in general – much more heavily weighted to illiquid investments, compared to a more broad-based peer group. Specifically, our survey results indicated that CIOs intend to boost illiquid investments to fully 55% of total plan assets within three years, compared to ‘just’ 34% for many of the benchmark E&F industry studies we reviewed.
6. However, there is now a growing focus on illiquid investments that provide more upfront yield. To offset the aforementioned trend of reduced realizations and more volatility in the equity books (especially given that significant multiple expansion led to outsized performance relative to history; see Exhibit 4 for details), many of the endowment and foundation managers we spoke with are planning to invest more dollars in Private Credit, Real Estate, Infrastructure, and select Private Equity. This response was noteworthy because, as we discuss in more detail below, most CIOs in this space tend to be much more growth-oriented.
7. This transition towards more Real Assets, including more collateral-based cash flows, definitely dovetails with our macro thinking. All told, 80% of our survey participants actually think that inflation will become embedded, creating a regime change for investing (shifting to a high inflation, lower real growth environment). As part of this change, CIOs are laser focused on not over-paying for investments and understanding true exposures and valuations. To this end, many are now considering meaningfully growing their Real Assets portfolio, albeit from a historically low base. This backdrop is actually somewhat of a conundrum, as many organizations just recently swore off natural resources in their portfolios as part of their ESG initiatives and in response to internal/external constituency pressures. As a result, they are now digging to find new ‘cleaner’ opportunities across Infrastructure, Real Estate, and climate change. Finally, several CIOs, as we detail later, are starting to use some of their excess Cash to buy higher yield Core Infrastructure as a substitute for energy’s inflation-hedging capabilities when liquidity is not a prerequisite.
8. Geopolitics is also top of mind, including both Russia’s invasion of Ukraine as well as tensions around U.S.-China relations. Portfolios are now being adjusted to reflect these growing concerns, with the U.S. being a net capital inflow ‘winner.’ Many CIOs are bracing for an era of de-globalization, which likely means potential limits on exposure to these ‘hot spots’. Our discussions led us to believe that many are now capping direct exposure to China at around 10% or less, while direct exposure to Russia will remain negligible. Maybe more important, most CIOs with whom we spoke agree that the change in the geopolitical landscape will lead to the growth we laid out in our ‘security of everything’ thesis, including in energy, data, transportation, and communications. Several also mentioned investing in funds that benefit from geopolitical dislocations, particularly those that can leverage the bullish fundamentals/volatility in asset classes such as commodities and currencies.
9. ESG remains a key area of focus, but the approach in the endowment and foundation community is different from what we see from other allocators of capital. All told, 70% of CIOs acknowledged ESG concerns were impacting their current and future investments. Yet, 50% had no plan assets directly committed to ESG funds. Why is there a disconnect? For starters, this community likely has been spending too much time on where not to invest (e.g., oil, coal, etc.). Second, CIOs are less focused on specific ESG funds and more focused on incorporating ESG into all aspects of their overall plan. To that end, CIOs are trying to deeply understand all ESG issues and then manage them as critical business issues that can also help drive change. The issues that garnered the most attention in our survey responses were the global energy transition, supply chain resiliency, and workforce development. In our view, these key areas will create significant investment opportunities for both specific funds and large asset classes such as Private Equity and Real Estate. However, there is a clear mandate to partner with ‘like-minded’ GPs who want to run their organizations in a more socially conscious and environmentally-friendly way.
10. Thematically speaking, our survey respondents still believe that we are in an era of innovation. We agree. However, we all acknowledge that the definition of innovation is expanding and changing. To this end, key high conviction themes include AI efficiency, automation, cyber, biotechnology, and crypto/block chain (e.g., 65% of CIOs have invested in crypto/block chain through a trusted VC manager). By comparison, ‘old’ technology such as social media, semiconductors, and streaming media appear both over-owned and higher risk to many CIOs.
11. In terms of macroeconomic worries, inflation ranked as the number one concern amongst CIOs surveyed. One can see this in Exhibit 2. This viewpoint is also supportive of the growing shift in asset allocation towards Real Assets that we heard during our interviews. The slowdown in economic growth amidst higher interest rates was also among the top three concerns highlighted in our survey. Importantly, though, as one CIO noted: “these concerns are somewhat of a circular argument as higher inflation means more Fed tightening, likely followed by slower growth.” That said, despite growing conviction that inflation is becoming more embedded, our CIOs thought, on average, that the U.S.-10 year would be at just three percent in 2023 (Exhibit 24) below our estimate of 3.5%.

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