Finance Weblog: Are private university endowments top investors?

A quick answer to this question seems to be a big YES, at least in the US and for a specific class of assets, namely, private equity investment. Recent evidence shows that, over the last twenty years, investments by university endowments in private equity funds have excelled, attaining returns that are on average 14 % greater than those obtained by their peers (pension funds, banks, insurance companies, etc.)

This is what economists call a puzzle or a conunundrum. Given the heterogeneity of institutional investors that populate the private equity business, how can one of these investors persintently obtain better returns?

Private equity investment is generally managed through a general partner (or group of skilled managers) that raise funds from a group of institutional investors (limited partners) for a long lock up period (ten years on average). Limited partners are generally endowments (public/private universities or foundations), public/corporate pension funds, insurance companies, banks, or investment advisors. Deals that private equity get into are generally classified as venture capital (in early or late stage) and leverage buyouts (LBO).

Across a large sample of private equity funds gathered from 1991 till 2001, Josh Lerner, Antoinette Schoar and Wan Wong* from Harvard University find out that private university endowments do better than their peers (20 % against a 6.7 % internal rate of return). This performance is mostly obtained in venture capital funds (35 % return for early stage fund and 19 % for late stage funds) whereas they do poorly in LBOs, obtaining just a meagre 1 % return

Several reasons may explain this performance. First, different institutional investors might differ in their risk profile. Endowments could be eager to take higher risks in exchange of higher returns. However this does not seem to be the case as one compares the variance of returns, which varies little across limited partners. Second, institutional investors could have different objective functions. Whereas endowments just want to maximize returns of the money allocated to them, banks might want to gain further business (in the form of fees) committing to specific funds. Nevertheless, this still could not explain why endowments also outperform other limited partners. A third explanation is that some limited partners had a first mover’s advantage or preferential access to better funds (the so-called grandfather rights). That is, because endowments were first to get into the business they have preferential access to funds when a new fund is opened. This argument is confronted with evidence that shows that endowments do not reinvest always in successful funds (those that had good returns in the past) and past performance does not guide their reinvestment decisions. Moreover when reinvesting in different funds, endowments do generally good.

Hence, the only explanation that can sustain the empirical evidence is that private universities have a large pool of human capital that can select optimally their investments. Human capital is what makes the difference!

*Josh Lerner, Antoinette Schoar and Wan Wong, Smart Institutions, Foolish Choices NBER Working Paper 11136, February 2005, www.nber.org

Asset allocation by Oklahoma State University Foundation:

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