ECONOMICS AND FINANCE
FOR ENGINEERS
February 6, 2009
Presented by:
William H. McLean, V.P. & CIO
Northwestern University
Agenda
 Understanding the Endowment
 Asset Allocation
 Active Strategies
 Hedge Funds
 Private Investments
Investments
2
Management Structure
Responsibility
•
•
•
•
Investment Committee
Investment Office
• Strategic and tactical issues for the
portfolio
• Due Diligence process/manager
selection
• Portfolio monitoring
W. McLean, VP & CIO
Public
Investments
AR
PI
Strategic Direction of Portfolio
Review Asset Allocation
Investment Policy
Oversight of manager hiring/firing
Oper.
3
Long-Term Endowment Fund Spending Rule
Market Element
=
30% weight
Spending Element
(Average market value for last 12 months times
long-term target spending or 4.35%)
Total $
(Millions)
= 70% weight
(Actual CPI + 1.51%)
$
Per Unit
%
Change
% Year-end
Market Value
1996
$55.2
3.62
+ 3.1%
3.59%
1997
$60.4
3.73
+ 3.0%
3.08%
1998
$70.3
4.17
+11.8%
3.53%
1999
$73.2
4.27
+ 2.4%
3.01%
2000
$95.5
5.30
+24.1%
2.92%
2001
$117.2
6.22
+17.4%
3.93%
2002
$130.2
6.56
+ 5.5%
4.67%
2003
$150.7
6.90
+ 5.2%
4.77%
2004
$160.4
6.87
- 0.4%
4.37%
2005
$161.4
6.75
- 1.7%
3.75%
2006
$176.2
6.81
+ 0.9%
3.39%
2007
$197.5
7.22
+ 6.0%
3.10%
2008
$233.5
7.80
+ 8.0%
3.36%
2009
$269.8 e
8.54
+ 9.5%
4.57% e
Investments
4
Investment Objective
“Preserve purchasing power of Investments and provide a
growing stream of Income for the University’s programs.”
or
Annual Total Return >
= Spending + Inflation
Investments
5
Investment Objective
Annual Total Return >= Spending + Inflation
As of December 31, 2008
1-year
Annual Total Return
3-year
5-year
10-year
15-year
-21.2%
2.9%
7.9%
8.0%
9.5%
- Spending
4.1%
3.6%
3.7%
3.9%
3.8%
- Inflation
-0.4%
2.0%
2.7%
2.5%
2.4%
-24.91%
-2.68%
1.55%
1.59%
3.31%
= Above objective
Investments
6
Endowment Growth
(Through August 31, 2008)
Spending
-$1,850
Appreciation
$4,821
Ending
Endowment
Value
August, 2008
Beginning
Endowment
Value (1992)
Net
Additions
$3,015
$6,942
$956
Investments
7
Endowment Assets
($ in billions)
Harvard University
43.9
Emory University
5.0
Yale University
22.8
Washington University (St. Louis)
4.7
Stanford University
18.6
University of Virginia Inv. Mgmt Co.
4.7
Princeton University
14.9
Rice University
4.1
MIT Inv. Mgmt Company
10.3
Vanderbilt University
3.4
DUMAC, LLC
7.4
Dartmouth College
3.3
University of Michigan
7.2
University of Southern California
3.0
University of Notre Dame
7.1
Brown University
2.9
Columbia University
6.7
Johns Hopkins University
2.8
#10 Northwestern University
6.6
New York University
2.4
Cornell University
6.3
UNC Management Company Inc.
2.2
University of Chicago
6.0
University of Pittsburgh
2.1
University of Texas System
5.8
University of Washington
1.9
University of California
5.7
Ohio State University
1.8
University of Pennsylvania
5.6
University of Toronto
1.7
Investments
Source: Cambridge Associates
8
Agenda
 Understanding the Endowment
 Asset Allocation
 Active Strategies
 Hedge Funds
 Private Investments
Investments
9
Long-Term Asset Allocation Process
•
•
•
•
•
•
Establish risk and return expectations
Establish constraints
Propose target portfolio and ranges
Compare target to peers
Approval of new target and ranges
Review of new asset class benchmarks
Investments
10
Conventional Asset Return/Risk Perspective
Investments
11
The Holy Grail of Investing:
15 or more Good, Uncorrelated Return Streams
Investments
12
Asset allocation using purely quantitative
mean-variance framework
10.00%
Private Equity
9.00%
Unconstrained
Frontier
Market Hedged
Expected Return
8.00%
Real Assets
7.00%
Current Holdings
6.00%
Intl Equity
5.00%
US Equity
Constrained
Frontier
4.00%
Fixed Income
3.00%
0.00%
5.00%
10.00%
15.00%
Expected Risk
Investments
13
20.00%
25.00%
30.00%
Asset Allocation (%) Trends
June 30, 1988 – June 30, 2008
50
45
45.3
Asset Allocation (%)
40
35
33.4
30
27.3 Marketable Alt.
25
22.3 Non-Marketable Alt.
19.5 Global ex U.S. Equity
20
15
10
5
0
13.5 U.S. Equity
11.0
9.4 Total Bonds
7.8 Equity Real Estate
3.7
2.9
2.9
0.7
0.2 Cash
1988 1990 1992 1994 1996 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
Source: Cambridge Associates
Investments
14
Asset Allocation gets more difficult when
dealing with multiple alternative asset classes
• Private Equity (Buyouts and Venture Capital)
– Illiquid assets not marked-to-market
– Long term (7+ years) investment horizon different than
that of publicly traded securities
– Separate asset class, but with “beta” to market
– Volatility does not capture true risk
• Hedge Funds
– Artificially created asset class; collection of investment
strategies that cover the breadth of asset classes
– Distribution of returns NOT normally distributed
Investments
15
NU Asset Allocation
Preliminary As of December 31, 2008
Actual
Target
Low Range
High Range
US Equity
10.5%
14%
11%
17%
International Equity
12.5%
16%
13%
19%
Fixed Income
10.4%
10%
7%
13%
High Yield Credit
7.9%
5%
2%
8%
Absolute Return
15.9%
18%
14%
22%
Private Investments
24.9%
20%
16%
24%
Real Assets
18.7%
17%
13%
21%
Cash
-0.7%
0%
Investments
16
Total Endowment Performance
Preliminary as of December 31, 2008
3 Months
12 Months
3 Years
5 Years
8.0%
3.0%
1.5%
-9.8% -10.3%
-21.0% -20.2%
Northwestern
Investments
17
Benchmark
5.5%
NU vs. Cambridge Associates’
Colleges and Universities
(September 30, 2008)
NU -11.2
7.9
12.0
20.0
15.0
10.0
5.0
0.0
-5.0
-10.0
-15.0
-20.0
1 Year
3 Years
5 Years
5th Percentile
-7.3
9.7
13.0
25th Percentile
-11.3
6.1
10.0
Median
-13.8
4.3
8.4
75th Percentile
-15.9
3.2
7.4
Percentile
95th
Investments
-18.8
1.8
6.2
Line 6
18
University Peer Returns (As of June 30, 2008)
3 Year
1 Year
5 Year
Harvard Mgmt Co.
8.64
Yale University
18.02
Yale University
19.14
University of Michigan
6.38
DUMAC, LLC
17.01
University of Notre Dame
17.83
Stanford University
6.23
University of Notre Dame
16.71
Harvard Mgmt Co.
17.61
DUMAC, LLC
6.15
Princeton University
16.30
University of Michigan
17.45
Univ of Virginia Inv Mgm Co.
5.93
Stanford University
16.12
DUMAC, LLC
17.44
University of Notre Dame
5.77
Harvard Mgmt Co.
15.96
Stanford University
17.18
Princeton University
5.58
University of Michigan
15.82
MIT Inv. Mgmt Co.
16.57
Yale University
4.50
MIT Inv. Mgmt Co.
15.72
Princeton University
16.54
University of Chicago
3.62
Univ of Virginia Inv Mgm Co.
14.97
Northwestern University
15.76
MIT Inv. Mgmt Co.
3.18
Northwestern University
14.82
University of Chicago
15.55
Northwestern University
2.90
Cornell University
14.53
Columbia University
15.38
Cornell University
2.72
University of Chicago
14.35
Cornell University
14.66
University of Texas System
2.35
Columbia University
14.12
Univ of Virginia Inv Mgm Co.
14.37
Rice University
2.16
Dartmouth College
12.79
Dartmouth College
14.28
Vanderbilt University
2.14
Rice University
12.51
Vanderbilt University
14.27
Columbia University
2.00
Vanderbilt University
12.25
Rice University
13.65
Dartmouth College
0.48
Emory University
11.02
Univ. of Southern California
13.28
Emory University
-0.43
University of Texas System
10.94
University of Texas System
13.20
Univ. of Southern California
-1.23
Univ. of Southern California
10.65
Washington Univ.-St. Louis
11.78
Washington Univ.-St. Louis
-1.36
Washington Univ.-St. Louis
10.24
Emory University
10.87
University of California
-1.93
University of California
9.52
University of California
10.68
University of Pennsylvania
-3.92
University of Pennsylvania
9.10
University of Pennsylvania
10.46
Source: Cambridge Associates
Investments
19
Agenda
 Understanding the Endowment
 Asset Allocation
 Active Strategies
 Hedge Funds
 Private Investments
Investments
20
Beta is pretty simple. What about “alpha”?
Right now, alpha comes from 3 places:
1) Traditional sources: Active Managers
• Alpha is integrated into the product, but is
easily identifiable
2) “Pure Alpha” sources: Hedge Funds
• The product is the alpha, with our without
some residual market beta
3) “Embedded Alpha” Sources: Private
Investments
• The alpha is inseparable from the beta, but
dispersion of returns among managers suggests
that alpha exists and can be large
Investments
22
Alpha production on top
of benchmark
b
a
Benchmark Return
Alpha of strategy
Residual beta of strategy
(may be zero)
Alpha and Beta are
integrated in strategy
Agenda
 Understanding the Endowment
 Asset Allocation
 Active Strategies
 Hedge Funds
 Private Investments
Investments
23
Allocation to Alternatives
Investments
25
Hedge Funds are characterized by nonnormal distributions of returns
Distribution of Returns - Hedge Funds vs. Stocks and Bonds
Monthly returns, May 1994-October 2003
40
35
# of Observations
30
25
20
15
Hedge Fund Returns: positively
skewed, lower risk than stocks
Bond Returns
(Lehman Aggregate)
Stock Returns: very risky, negatively
skewed, in other words there is
significant negative tail risk
Hedge Fund Returns
(NU net returns)
Bond Returns: not very risky, and
are slightly negatively skewed
Stock Returns
(S&P500)
10
5
Investments
Monthly Return (%)
26
9%
10
%
M
or
e
8%
7%
6%
5%
4%
3%
2%
1%
0%
-2
%
-1
%
-3
%
-5
%
-4
%
-6
%
-8
%
-7
%
-9
%
-1
0%
0
Five Broad Hedge Fund Categories
Encapsulate Many Distinct Strategies
1
LONG-SHORT EQUITY
3
RELATIVE VALUE STRATEGIES
2
LONG-SHORT CAP STRUCTURE
4
GLOBAL VALUE
5
MULTI-STRATEGY*
INSTRUMENT
EQUITY
STYLE
VALUE
ARB
*Note:
Investments
CAPITAL
STRUCTURE /
CREDIT
INTEREST
RATES
COMMODITY
MULTIPLE
L-S (Jones Model)
L-S (Mkt Neutral)
L-S (Short Bias)
Deep Value / Catalyst Interest Rate Value
Cap Str Arb / Distress
Distressed Active
Commod. Value Macro
Merger Arb
Stat Arb / Prs Trading
Equity Deriv. Arb
Convertible Arb
Commodity Arb
Fixed Income Arb
Mortgage Arb
Multi-Strategy*
Multi-Strategy managers implement subset of all other strategies across the broad categories
(indicated by different colors), and allocate risk to the strategies in a proprietary manner.
27
Hedge Fund Risk Management
•
•
•
•
•
Understand the strategies
Understand the correlation among strategies
Understand opportunity set of each strategy
Set allocation to strategies appropriately
Find the best managers to execute strategies,
with strong emphasis on trust and integrity
Investments
28
Non Market Risks Associated with Hedge Funds
Large Variation Across Strategy
•
•
•
•
•
•
•
•
Limited History of Operations
Leverage
Tail Risk & Correlation Convergence
Liquidity & Concentration of Portfolio
Style Drift
Short Volatility
Organization & Back Office
Fraud
Investments
29
Agenda
 Understanding the Endowment
 Asset Allocation
 Active Strategies
 Hedge Funds
 Private Investments
Investments
30
Buyouts Fundraising
U.S. Buyouts and Mezzanine Fundraising
300
$282
$ Raised (billions)
250
$226
$205
200
$169
150
$94
100
50
$70
$47
$49
$58
$28
$73
$46
$33
0
Source: Buyouts
Investments
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 YTD
3Q 08
31
Venture Capital Fundraising
Venture Capital Fundraising
$40
250
$ in billions
$32
200
$28
$20
$24
$19
150
$10
$11
$4
$0
100
2002
2003
2004
2005
Source: NVCA
Investments
32
2006
2007
YTD 3Q
08
Number of funds
$35
$30
Venture-backed Exits
400
300
350
250
M&A
300
250
200
150
150
100
100
50
50
IPO
0
0
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
Source: Venture Economics & NVCA
Investments
33
# of IPOs
# of M&A Exits
200
Trends in Private Investments
•
•
•
•
•
•
•
•
•
FASB 157
Denominator Effect/Quest for Liquidity
Secondary Transactions (LP and GP)
Tough Fundraising Market
Emerging Markets
Longer Holding Period
Shake-out in the system? Is the model broken?
Increased # of Investors in the Market
Difficult to Access Top Tier Managers
Investments
34
Private Investments: Emergence of Mega Funds
Prior to 2004
2004 -2006
9
3
0
19
10
5*
Funds > $3.5bn
Funds > $6.0bn
Funds > $10bn
* Includes funds scheduled to close/closed in 2006. Apollo, KKR, Bain, TPG,
Blackstone.
Source: Willis Stein Partners
Investments
35
Nine of the ten largest deals occurred in
2005/2006
Acquisition
HCA (US)
Date
Announced
Jul 2006
Deal
($ Billions) PE Firms
$31.6
Bain, KKR,Merrill
RJR Nabisco (US)
Oct 1988
$30.6
KKR
Kinder Morgan (US)
May 2006
$22.0
Goldman, Carlyle, Riverstone
Albertsons (US)
Jan 2006
$17.4
Cerberus, Blackacre, Lubert-Adler
TDC (Denmark)
Nov 2005
$15.3
Apax, Blackstone, Providence, KKR, Permira
Hertz (US)
Sep 2005
$15.0
CD&R, Carlyle, Merrill
GMAC (US)
Apr 2006
$14.0
Cerberus, Citigroup, Blackacre
Univision (US)
Jun 2006
$12.3
MDP, Providence, TPG, TH Lee
Sungard (US)
Mar 2005
$11.4
VNU (Denmark)
Jan 2006
$11.0
Bain, Blackstone, Goldman, KKR,
Providence, TPG, Silver Lake
KKR, TH Lee, Carlyle, Hellman & Friedman
Highlighted deals represent Northwestern’s Exposure
Investments
36
GP Management Company Sales
• Retention tool or cashing out?
General Partners
Natural Gas Partners
Avenue Capital
Fortress Investment Group
Lansdowne
Ospraie
Silverlake
Blackstone
Investments
Amount
40%
20%
25%
20%
20%
9.9%
$3bn
37
Acquiror
Barclays
Morgan Stanley
Nomura (15%); IPO (10%)
Morgan Stanley
Lehman Brothers
Calpers
China
NU Alternatives Portfolio
• Investment program began in 1993
• Four managers oversee the program
• Currently represents 50% of the total endowment
– Includes hedge funds, buyout, venture capital partnerships,
real estate, energy and a Co-investment program
• Mature portfolio but with opportunities to diversify
• Long term investor mindset
Investments
38
NU Private Investments Portfolio
• Currently represents 20% of the total endowment
– Includes buyout, venture capital partnerships, Coinvestment program
$ Millions
PE Domestic
Venture Capital - Domestic
PE International
Venture Capital - Intl
Coinvestments
Totals
Investments
# of Mgrs # of Funds Committed
26
58
$1,101
33
83
$950
16
27
$448
9
19
$167
16
NA
$67
100
187
$2,733
39
Called
$843
$640
$254
$88
$42
$1,867
Uncalled
$258
$310
$194
$79
$25
$866
The Investment Process
1. Review Private Placement Memorandum and
have initial meeting with GP
2. Follow-up meetings
3. Due diligence
4. Investment Memorandum
5. Negotiation of terms
6. Receive Approval from Investment Committee/
Closing
7. Monitor performance, build relationship
Investments
40
Due Diligence
1.
2.
3.
4.
Investments
Strategy
Management Team
Performance
Terms
41
Strategy
•
•
•
•
•
Consistency across funds
Differentiated in the marketplace
Fund size supports strategy
Deal sourcing ability
Deal structuring
– Purchase price multiple, leverage, management
ownership
• Ability to exit in various markets
Investments
42
Management Team
• Background
• Cohesion
– Tenure of the team? Stable partnership?
•
•
•
•
Carried Interest allocation within team
Deal and board capacity
Motivation of team
Reference checks
Investments
43
Performance
• Realized deals
– Source of realization: disposal, dividend, recap
– Dispersion of returns
• Unrealized deals
– Current valuation method: 3rd party, EBITDA multiple at
purchase vs. market, public shares
• Deal attribution by partners
• Source of value creation
• Gross IRR/Multiples v. Net IRR/Multiples
Investments
44
Terms
•
•
•
•
•
•
•
Management fee
Carried interest
GP commitment
Key man provision
Clawback (guarantee)
No fault divorce clause
Transaction fees, director fees offset
Investments
45
Questions