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    Finance

    What pension funds could learn from Yale

    by Raphaël Grieco Published November 29, 2024 in Finance • 6 min read

    The endowment funds of Yale and other leading universities are successfully investing in venture capital to supercharge returns. While caution is needed, traditional pension funds could benefit from following their approach.

    Traditional pension funds have much to learn from the runaway success of university endowment funds in the US, where Yale and others are reaping the benefits of investing heavily in hedge funds, venture capital, and real estate.

    With inflation eating into yields and growing pressure to meet long-term obligations, the need to integrate VC into portfolios has never been more pressing. The results of the endowment model can be spectacular. Yale’s asset allocation is modeled to deliver close to 12% over the decade, twice that of a more conservative 60/40 allocation of stocks and bonds. 

    An endowment portfolio typically encompasses a wide array of asset classes, including hedge funds (23%), private equity (22%), and real assets (11%) such as infrastructure, timberland, and real estate. 

    Of course, the reluctance of traditional fund managers to leap in is understandable. Pension funds operate under different structural and governance constraints, with the need to match predictable liabilities while maintaining a strong liquidity position. 

    Yet, it’s a risk worth taking. Here, I will show how pension funds can adapt the endowment model to their unique contexts, strategically unlocking VC’s potential while managing the risks of illiquidity. Note that this is a high-level framework, and each pension fund has its own dynamics. 

    Leveraging the fixed income portion of the portfolio as a liquidity buffer is a secure way of ensuring that pension funds maintain long-term VC commitments across cycles

    Tailoring the endowment model to pension funds’ characteristics

    1. Time-locked VC investments to match long-term liabilities. Pension funds can align VC payout modeling with their liability schedules to ensure long-term illiquid investments complement their future payout obligations. A conservative approach should be favored, given that private companies stay private longer, extending the timespan between capital call and distribution.
      Consider a pension fund with substantial liabilities starting in 2035. By committing to a VC fund in 2024, the fund can align its capital commitments with its payout schedule. The VC fund calls capital over the next four to five years as it invests in companies. By 2034-2036, the VC fund begins to realize successful exits, generating cash distributions that the pension fund can use to meet its obligations, allowing the pension fund to leverage the potential alpha from venture capital while ensuring it has the necessary liquidity to cover retiree payouts, thus avoiding forced sales of liquid assets in the interim.
    2. Risk-specific capital buckets for illiquid assets. Creating dedicated sub-portfolios for VC and other illiquid investments is a powerful risk management strategy for pension funds. This approach allows for more effective risk management by segregating venture investments from the liquid part of the portfolio. The idea is not to isolate VC but to have a specific management style, given its illiquidity and low transparency nature. This includes accepting infrequent mark-to-market valuations, unlike the regular assessments typical in public equities, and maintaining them for several quarters without modifying them, exemplifying a dedicated approach to managing sub-portfolios for venture capital. Also, segregating a VC portfolio could imply engaging specialized external managers focused on VC, establishing specific performance metrics, and setting liquidity limits to ensure VC exposure does not exceed a certain percentage of the overall portfolio.
    3. Leveraging fixed income for liquidity support. Given that pension funds typically have greater exposure to fixed income than endowment funds, leveraging the fixed income portion of the portfolio as a liquidity buffer is a secure way of ensuring that pension funds maintain long-term VC commitments across cycles while meeting short-term obligations.
    “By engaging in secondaries, pension funds can balance long-term illiquid commitments and near-term liquidity needs, enhancing their ability to respond to evolving market conditions while reaping the benefits of private market exposure.”

    Managing illiquidity and commitment risks with strategic allocation models

    1. Contrarian VC deployment during market downturns. Pension funds should consider deploying capital to venture capital when public markets are weaker and VC valuations are more favorable, as these conditions offer better long-term opportunities. As an illustration, according to Commonfund, if you evaluate venture fund vintages during the Global Financial Crisis (GFC), the industry experienced outperformance compared to the years leading up to the recession.
    2. VC commitment pacing based on funding ratios. One effective way for pension funds to manage their venture capital commitments is by tying them to funding ratios, also known as “coverage ratios” in Switzerland. This approach ensures that the allocation to illiquid assets grows in line with overall financial health, thereby keeping liquidity risk in check. With most Swiss pension fund coverage ratios showing improvement in 2023, it’s a timely opportunity to reassess VC from a strategic investment perspective.
    3. Layered liquidity across private markets. Pension funds can create natural liquidity events by diversifying their illiquid investments across asset classes with varying liquidity timelines (VC, private equity, real estate), ensuring smoother cash flows and more strategic flexibility. Moreover, pension funds can tap into secondary markets to add another layer of flexibility. In the secondary market, pension funds can buy or sell stakes in venture capital or private equity funds before the investments fully mature (or invest as Limited Partners (LPs) in General Partners (GPs) doing precisely that). This allows them to realize liquidity sooner, exit underperforming investments, or adjust their allocations without waiting for the standard exit horizons. By engaging in secondaries, pension funds can balance long-term illiquid commitments and near-term liquidity needs, enhancing their ability to respond to evolving market conditions while reaping the benefits of private market exposure.
    Pension funds must continuously refine their approach, staying informed on evolving market dynamics, new fund structures, and emerging opportunities.

    Governance and investment process innovations for VC integration

    1. Specialist teams for strategic VC decisions
      Pension funds can leverage dedicated in-house teams to make long-term, strategic VC allocations. These teams focus on identifying the best opportunities, mostly building as LPs sound and long-term relationships with VC GP managers and ensuring that investments and relationships align with pension fund objectives across vintages, economic, and innovation cycles.
    2. Sector-specific VC allocation for strategic alignment
      Pension funds could concentrate on venture capital investments that align with beneficiary demographics or economic trends, such as decarbonization and impact, ensuring that VC investments serve financial and strategic purposes.
    3. Periodic VC performance monitoring for strategic adjustments
      Regular performance reviews (quarterly or bi-annually) and check-ins allow pension funds to assess how their VC investments and relationships are performing. While immediate rebalancing isn’t needed, and for the most part not possible given the illiquid nature of VC, these reviews help inform future capital commitments and strategic adjustments to the VC portfolio.

    Adapting the endowment model around VC into pension fund portfolios presents unique challenges and compelling opportunities. No doubt, the illiquid nature of this asset class, combined with the long investment horizons, requires careful planning, robust risk management, and strategic liquidity layering. Yet, given the power law nature of VC, the known potential for outsized returns, or alpha, makes venture capital a valuable tool for pension funds seeking long-term growth.

    However, involvement in this space is not static: it demands a deep, ongoing education and an adaptive understanding of venture investing. Pension funds must continuously refine their approach, staying informed on evolving market dynamics, new fund structures, and emerging opportunities, to fully grab the potential of this complex yet rewarding asset class. 

    Authors

    raphael grieco

    Raphaël Grieco

    Research Associate at the IMD Venture Asset Management Initiative

    Raphaël Grieco is a former Research Associate at IMD for the Venture Asset Management Initiative, drawing on over 15 years of leadership experience at the intersection of cross-asset wealth management and technology. Raphael specializes in early-stage venture investing, multi-support educational content creation spanning written and audio formats, as well as building entrepreneurial ecosystems focusing on technology (including crypto and web3).

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