The Endowment Model Becomes MainstreamTheEndowmentModelBecomesMainstream

Modelling and Capacity

Institutional investors who allocate to both public and private market assets have two main concerns. The first is modelling and benchmarking: from a portfolio construction perspective what is the optimal allocation to private markets and how do you measure risk and return, manage cash flows and decide on a rebalancing policy?  The second concern is around capacity: with private market investments becoming mainstream, can returns be expected to be as strong as in the past, and how can you find opportunity in such an environment?

Strategic asset allocation is usually conducted using stochastic models and mean-variance optimisation to arrive at an efficient portfolio; such models are very sensitive to assumptions used, not just about expected returns, but also volatility and correlation. Combining private and public markets investments in an asset allocation model needs to take into account the apparent lower volatility of private markets (because they are not marked to market), but also importantly cash-flow risk (ensuring there is sufficient cash to meet liabilities and capital calls in various scenarios and that generated cash is reallocated efficiently) and when or if to rebalance if sudden changes in public market valuations cause the strategic allocation to diverge from the norm.  PGIM’s IAS team has developed its OASIS model and has written a number of  research publications to help institutional investors address these questions. Click here to learn more about IAS.

And, if some areas of private markets may become crowded, where can we find future returns? Part of the answer may be in allocating to non-core opportunities such as:

• Real Estate Debt which can generate attractive yields relative to public market equivalents, with real asset collateral 
• Direct Lending, particularly lenders focussed on lower to middle market corporates, who are less reliant on large private equity-sponsored deals, and
• Private Equity Secondaries: Many investors have legitimate reasons to want to sell LP positions early, secondaries not only provide liquidity to that group but also allow new investors the ability to join existing partnership, often at a discount and with no J-curve.

Finding the Best Managers

The other important element of the endowment model for Swenson, and one of the reasons Yale has been so successful, is manager selection. He placed great weight on picking the best and had a preference for specialists, who thought differently from the mainstream and knew their niches and stuck to them. Quoted in the Yale Alumni Magazine in 2005 he said, “You want people of high integrity, high energy, high intellect, people who are obsessed with the market.”  PGIM’s multi-boutique model is designed to allow exactly this kind of focus to flourish within its specialist asset class teams.