For college endowments, this has been the worst year since the financial crisis—and next year might not be much better. In addition to the selloff in stock and bond markets, many endowment funds are sitting on as-yet-unrealized losses in private-equity and venture-capital holdings, on which they loaded up in recent years.
Alternative assets’ strong performance helped endowments put up an average gain of 30.6% in the fiscal year ended on June 30, 2021, and provided a buffer against losses in stocks and bonds in fiscal 2022. Endowments shed a median 7.8% in the latest fiscal year, according to Cambridge Associates, against a drop of 10.6% in the
index. Write-downs of private-equity and venture-capital positions are likely to ding performance further in fiscal 2023.
So says Stephanie Lynch, co-founder of Global Endowment Management, a Charlotte, N.C.–based firm that oversees $11.2 billion for endowments, foundations, and nonprofits. Global Endowment Management, or GEM, acts as an outsourced chief investment officer, or OCIO, for clients, including the Rhode Island School of Design, the New York Blood Center, and the Woods Hole Oceanographic Institution. GEM, launched in 2007, manages institutional portfolios that range in size from $25 million to $1.5 billion, with average assets of $225 million.
Barron’s recently spoke with Lynch about the challenges and opportunities facing endowments now that higher inflation and interest rates, and greater market volatility, have put an end to the easy money made during the bull market’s historic run. An edited version of the conversation follows.
Barron’s: Many endowment managers lost money in the latest fiscal year. What lies ahead?
Stephanie Lynch: Fiscal 2022 presented a sharp contrast with fiscal ’21. It was a year in which institutional reliance on private alternatives helped stem the losses in the public markets. It will be interesting to see how things shake out in fiscal 2023. We know that the valuations of venture-capital holdings will have to moderate somewhat, given this year’s selloff in technology stocks. We expect to see some drag on private-equity valuations, but it’s not the same.
What’s the difference?
Buyout [valuations] at the smaller end of the spectrum didn’t get written up dramatically in 2021. We wouldn’t have expected them to take many hits in 2022. Deals that didn’t involve a lot of leverage haven’t been impacted much by the rise in interest rates, and they aren’t impacted by markets. Valuations are driven by what is going on at the company level.
Should smaller endowments be invested in private equity and other alternative assets?
Alternative-asset managers need assets and scale. If a small endowment can find a partner with both, it’s fine to invest in alternatives. But it’s challenging to find vehicles that aren’t laden with additional fees, on platforms that don’t have added fees. High fees mean returns have to be shared with many other parties. Accessing private equity depends on the vehicle you use. We pool client assets to invest in alternatives, and have been able to invest with the leading private-equity and venture firms.
Are you involved in every aspect of your clients’ portfolios?
Our role is to be the outsourced investment office for smaller university endowments and foundations that are trying to mirror or replicate what the large endowment offices do. For years, it has been as much about governance and execution as investment returns. Those issues are going to become even more important as we figure out how to live on lower returns and lower endowment values, which may be the case for quite a few years.
How are you and your clients thinking about this transition?
We have enjoyed what we call the great moderation: a period in which valuations benefited from lower interest rates and all the tailwinds associated with them. Now, we are looking at the great volatility. Higher interest rates are going to be a durable trend, and market volatility is here to stay.
We are looking at lower global growth due to demographics, deglobalization, and increased foreign conflict. We are going to have to deal with higher structural inflation due to the gradual loss of cheap labor and efforts to make supply chains more robust. Asset allocation is really going to matter.
The correlation between stocks and bonds was negative for almost all of the 40 years in which we have grown up in the endowment investment world, and we are finally starting to see that change. When interest rates go up, that hurts bonds, and it hurts stocks. Where do we hide? We have to look at some equity surrogates and diversifying assets that have been propping up values of late. That includes commodity-related investments and real estate.
Where do you see the best investment opportunities now?
We’re always thinking beyond any single fiscal year. However, we expect a challenging environment as markets reprice for the possibility of a new economic regime. With stocks and bonds more correlated, we expect that nonprofits will ratchet up the hunt for uncorrelated returns, that there will be more interest in resource-related investing, and that investments in defensive sectors that can weather recession may be in favor.
In private markets, investors are likely to continue to back their highest-conviction managers, while slowly moderating exposure. In some respects, this will be a story of endowments unwinding some portfolio overweights to long-duration assets that have been such strong drivers of return over the past few years and tilting back toward more balanced exposure.
What is your outlook for U.S. stocks?
We don’t attempt to forecast equity markets or bond yields in the short run. That’s an impossible game to play. With recession risk high, we are underweight equity and credit investments and prefer cash and TIPS [Treasury inflation-protected securities] to nominal bonds. We also remain overweight inflation-sensitive assets. Recessions are bad for commodities, as any weakness to aggregate demand hurts things priced at the margin. However, this capital cycle is far different from the financial crisis. Decades of underinvestment have impaired supply, and the shift from financial assets to real assets has further to run.
You’re also diversified internationally. Have you invested in China?
We are loath to make sizable macro bets. We have maintained a market weight relative to the global stock index in our public portfolio and prefer to invest through active managers, both long and short. Manager selection in China is incredibly important. One reason why we like China is because it is one of the largest markets with the highest share of retail investors.
We’ve been underweight the European markets, a theme in the portfolio for quite some time. But the damage has been done with respect to Europe’s dependence on Russia for energy. Even if the conflict in Ukraine were to end tomorrow, it wouldn’t have a material impact on European economies in the short run. A lot of things still have to be worked out.
One thing we are talking with clients about is that international risk is going to a much more important part of the conversation. We are going to spend a lot more time focusing on macro views.
How does GEM handle blockchain and other crypto investments?
“The markets have room to fall from here, because the Fed is going to overshoot…in the time they’re willing to hold a restrictive policy stance.”
We have a small position through some of our venture investments, largely in companies building the infrastructure for the crypto ecosystem. We don’t have a view on whether or not the crypto industry is going to be more or less significant over time, but we do have a view that there will be high dispersion—significant winners and losers. Our venture managers are best positioned to develop an edge and make judgments about innovation areas such as crypto, artificial intelligence, longevity science, and such.
What are the key trends in the OCIO business?
It’s hard not to imagine that the role an investment office plays in the support of an endowed institution is only going to become more important. Clients are going to be faced with lower investment returns, which means execution is paramount.
Do you continue to see interest in investing through an environmental, social, and governance, or ESG, lens?
I’m seeing a lot more interest, especially with all of the negative press associated with ESG funds and what they were designed to do, versus what they ultimately returned and how they were marketed.
There is a lot of distrust in the marketplace about them. And yet, there is a continued concern about mission alignment for our foundations. They want more alignment with their mission and their investments. They feel a great sense of responsibility for that capital. The three issues that play a role in every impact investment we make are diversity, equity, and climate-change solutions. It’s a big area for us.
What will keep you up at night for the rest of this year, and into 2023?
The markets have room to fall from here because the Fed is going to overshoot, likely not in the peak level of interest rates but in the time they’re willing to hold a restrictive policy stance. The equity-market rallies that we saw in July and through much of the fourth quarter so far suggest that market participants aren’t quite ready to accept that. Rates markets are pricing in a Fed pivot—cuts in interest rates in early 2023—and this is premature. There will be some disappointment with that.
The other issue is that we haven’t had enough time for interest rates to impact economic activity. The yield curve is deeply inverted. You are starting to see housing markets turn down and earnings estimates for 2023 fall. Financing activity for leveraged buyouts is beginning to slow.
The transmission mechanism between monetary policy and the real economy isn’t immediate, and we’ve just gone through one of the fastest hiking cycles ever, into an environment where valuations were propped up on a decade of free liquidity. It is logical to expect that we are heading into some form of recession once all of the implications become clear. I am hopeful that it won’t be a severe one, but we are holding a conservative posture as a result. We have the luxury of taking a long-term view, but protecting against the downside is the right posture at this point in the cycle.
Thank you, Stephanie.
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