Raghav Bhatter

VCPE Assignment
Submitted in Partial Fulfilment of course Venture Capital and Private Equity.
Submitted to Professor Sanjay Shanbhag

1. How should Yale allocate its new commitments? For example, how should the new
investments be allocated across venture, buyout, international, and natural resource funds?

What should be the mix between new groups and established organizations? Should Yale
expand its international program to include greater emphasis on Asia and continental Europe?
Ans:
The Yale Offices investment philosophy was driven by five investment principles. The principles can
be listed as follows:
1. Strong belief in investing in equities
2. Hold a diversified portfolio
3. Seek opportunities in less efficient markets
4. Use outside managers for most investments
5. Dont ignore the explicit and implicit incentives of investment managers.
The Office also allocated 17% of its portfolio for private equity funds, which engage in leveraged
buyouts, mezzanine financing, venture capital and company acquisition. The Office used the same
approach for private equity fund managers as it did with its equity managers.
The Office allocates 25% of its funds to absolute return funds. Absolute return funds are a broad
group of funds that attempt to produce a positive return regardless of the performance of the market
as a whole. However, the funds use a wide variety of strategies that employ stocks, bonds,
commodities, short selling, futures, options and other derivatives, arbitrage and anything else that a
financial genius can devise.
Real assets constituted about 27% of the targeted portfolio for the endowment and are among its
most illiquid. The real assets the Office invested in are categorized as real estate, oil and gas fields,
and timberland.
The Office had over 25% of the endowment allocated to publicly traded equities, which was
substantially lower than its peers. The Office decided that passive index investments were not going
to be a part of its equity portfolio.
The bond investments and cash holding investments are used as hedges against market volatility.
The Office manages bond investments internally with a target weight of 4% with a maximum allowable
weight of 5%.
The Office used mean-variance analysis to help it make asset allocations. However, it did put limit
some of the possible solutions by placing limits on the proportion of the endowment that could be
invested in any particular asset class to ensure a certain degree of diversification. Otherwise, its
optimization model would leave out whole asset classes.
Some of the asset classes were simply considered as hedges against a worst case market melt own.
The limits were also necessary because the Office knew that the relationships between different asset
classes change over time, so it could not completely rely on historical relationships. The asset class
limits were also an acknowledgment that there were limits to the Offices ability to assess future risk.
That also meant that the Office ran five- and fifty-year Monte Carlo analyses for downside risk in
proposed portfolios. As the Office become more knowledgeable and comfortable with private equity
and other less common asset classes, it increased its diversification by asset class and increased its
allocations to classes that produced higher average returns.
Given what is known about near-term possibilities in the U.S. and around the world, it would be
prudent for Mr. Swensen to adjust his private equity strategy. The Office has done a great job of
finding talented and consistent private equity managers. According to me, the following Strategy
should be used for allocation:
- Increase allocation of assets invested in private equity. This also applies to international private
equity. Overall, private equities have had a higher Sharpe ratio than U.S. equities. Therefore, a little
added risk can produce a much greater reward. Also, as much as private equity has contributed to the
growth of the endowment, it still would beat its peers without its influence.
- Increase allocation of real assets. Although it would increase the illiquidity of the endowment, real
assets provide certain long-term benefits. They can produce income even when the market value is

down. All forms of real assets are under demand pressure from a growing U.S. population, so they
should continue to outperform the market because the Office can wait until their disposition maximizes
their return. Demand for commercial property in desirable areas, developable land, oil and gas and
wood-related products are only expected to increase. Global and domestic oil and natural gas
consumption are only expected to increase in the U.S. and globally with time.
- Increase the allocation of foreign equities. Currently, the economic growth engines are overseas and
the best way to take advantage of that is to be invested in those markets, where it is complementary
to the Offices investment strategy. So Yes, Yale Should expand its Operations into International
Market.
- Eliminate bond holdings for stable dividend paying stocks. The Office would be better off investing its
funds in a high-quality equity-income fund because it would produce higher returns and have an
upside in capital appreciation in exchange for the increased volatility. Many dividend paying blue chip
stocks are stable with consistent cash flows and modest growth. Volatility aside, firms like McDonalds
actually do better during recessions because they are cost competitive, which explains how their CEO
managed to increase U.S. same store sales by 50% in 7 years. Many utilities are cash cows and are
reliable sources of income.
- Reduce holdings in absolute return funds. Many absolute return funds have high correlations to the
stock market, which makes them slightly redundant and not as good for diversification as thought
(Dan Jones, Investment Week, February 20, 2012). The same task of producing returns during a
down market can be addressed by private equity funds.
The investment allocation recommendations could potentially increase the risk of the endowments
portfolio if there is too much duplication in the portfolios of the various public and private equity funds
that the Office invests in. Also, market cyclicality periodically affects real assets and the price of gas
and oil have become more volatile due to the speculators and futures market, which makes guesses
or assumptions about the price of oil or gas in the future.
Additionally, the lack of transparency in some emerging markets could be hiding potential time bombs
in terms company profits, currency deflation or regime change.
There are country risks that have to be managed in the Offices foreign equity and international private
equity investments. Increasing international investments may not increase market volatility, but may
have other risks, such as asset nationalization, such as occurred in Venezuela. Events like continued
conflict in the Middle East are likely to hurt the overall global economy, while providing increased
returns for holders of oil and gas assets. So, gains in some asset classes could come at the expense
of others.
The Office sought to expand its private equity investments outside of France and the UK to emerging
markets. There were fewer funds competing for deals. However, it made its international private equity
investments while avoiding those funds associated with large financial institutions.
Those types of arrangements also made it more difficult for the Office to assess their
performance and record. Those made the Office consider looking at the global private equity funds of
well-established US private equity firms. In the end, the Office was able to find a number of new
emerging market funds that were better incentivized than the larger global funds because they were
run by general managers who were not bothered by co-investment or the Offices approach to
compensation. They were run by experienced and hungry to take advantage of known opportunities.
One of the noticeable differences between its strategy with domestic versus international private
equity managers was that international private equity was primarily with smaller firms with favourable
compensation structures. Also, there were more opportunities to produce excess returns
internationally than in the U.S., where private equity was getting larger and larger with more firms
pursuing the available deals. Past experience with international private equity had produced
annualized average returns in the mid-20s, but the returns had been much more volatile and risky
than those in the U.S.

2. In the long run, would it be viable for Yale to adopt an asset allocation that was considerably
different from that of its closest peers, such as Harvard, Princeton, and Stanford? More generally,
could these few endowments as a group persist with asset allocations that were very different from
those of almost every other institutional investor?
Ans:
Yes, i feel that Yale should pursue asset allocation that is considerably different from Harvard, Princeton
and Stanford. In 1930s, equities represented 42% of the Yale endowment, the average university had just
11%. However, Yale was successful in avoiding the great depression of 1930's as many of its recent
bequests then were kept in either cash or treasuries rather than being invested in equities.. Given the
scenario that unfolded later on, the then treasurer decided that share of equities in Yale's Portfolio should
be drastically reduced and the changes in the tax structure would ensure no receipts to equity holders even
if the market conditions were to improve. Hence, given the situation that came up, investment in fixed
income securities had to be increased so as to ensure reliable returns to investors. Also, i feel that above
mentioned investment allocation percentage would suite Yale more and provide the investors with
adequate return. The Theory says that. "Higher the Risk, Higher the Returns", and this case is no different
but the marginal change in returns would be greater than that of risk thereby justifying the riskier
investment. Also, it is possible for each of the group to survive with asset allocations different from that of
an institutional investor.

On Exploring the Fund's reinvestment strategy, it can be found out that endowment funds generally
are much less likely to reinvest in a given partnership. Funds in which endowments decide to reinvest
show much higher performance than those where endowments decided not to reinvest. In fact,
corporate pension funds and advisors are more likely to reinvest if the current fund had high
performance, but this does not necessarily translate into higher future performance. These findings
suggest that endowments proactively use the information they gain as inside investors, while other
LPs seem less willing or able to use information they obtained as an existing fund investor.
So, all in all, it is possible for endowments to have asset allocation different from that of an institutional
investor.