Liquidity and Capital Calls at the Yale Endowment

Seth Hettena has a very interesting interview with Yale's David Swensen, in which Swensen pooh-poohs the meme which has been going around of late that university endowments have major liquidity problems and that they're quaking at the prospect of capital calls from their private-equity investments, to the point at which they'd rather sell those investments on the secondary market at a steep discount than hold on to them and keep the potential future liability.

Swensen is not a typical endowment manager, of course -- but neither are the people at Harvard, and I've definitely heard the private-equity meme applied to them. So it's worth understanding why Swensen isn't particularly worried either about liquidity or about private-equity capital calls. Which, incidentally, is as it should be: endowments are ultra-long-term investors whose job, to a large degree, is to pick up illiquidity premia where they can find them.

First Swensen addresses liquidity:

There are a number of tools that an endowment should have at its disposal to deal with liquidity issues. There are actually lots of ways that portfolios generate liquidity. Some of them are quite pedestrian. You've got dividends from stocks, rents from real estate holdings, logging income from your timber interests, coupons on your fixed-income investments. Those are all sources of liquidity. You also have the ability, if you've structured yourself properly, to generate liquidity by pledging securities positions. In the bond world, you've got the repo market. In the equity world, you've got the security-lending market. You're essentially using those assets as collateral for short-term loans, generally at very favorable terms, without altering the underlying portfolio characteristics. On top of that, you've got the ability to borrow externally. You also have the ability to sell positions, but that's disruptive to the portfolio...
We dealt with 1987. We dealt with 1998. We actually dealt with some liquidity issues surrounding the Internet bubble as well, because we'd hedged a lot of positions in these crazily valued Internet stocks. The hedges required a substantial amount of liquidity support. And so we've got the tools available to us, and we've had the experience of using the tools, and we've been able to do what we needed to do without using any of these disruptive sources of liquidity.

This all makes perfect sense to me. Endowments have liquidity needs: they pay out substantial sums to their respective universities each year, and of course they need a certain amount of liquidity just to be effective investors. But if they're set up in such a way that they can meet their liquidity needs with the cash thrown off from investments, plus a bit extra from things like repos, then a liquidity crunch like we're seeing right now shouldn't affect them too badly.

As for private-equity capital calls, says Swensen,

Right now, they don't appear to be much of a problem at all because the credit markets are broken. You hear a theme? Most of what it is that would be subject to call involves the use of leverage. For example, a leveraged buyout or purchase of real estate would involve leverage. You're seeing the occasional deal, but things have been pretty quiet...
Just looking at what's going on in the industry, I don't see it. Things are very, very quiet.

I'm not sure I buy this entirely. Swensen's right that private-equity shops aren't going to be using a lot of leverage any time soon when they go into new deals. But doesn't that mean that they need more capital, rather than less, if they want to buy any given asset? Isn't the point of leverage that you don't need to make a capital call on your limited partners, because you can just borrow the money instead?

Still, more generally it's surely true that private-equity companies aren't in any rush to start tapping their LPs for more cash. They have cash already, and that cash is becoming more and more valuable as asset prices continue to decline. It's conceivable that at some point in the medium-term future, they will have run out of that money and need some more. But we're not there yet, and it's not worth dumping private-equity stakes into an illiquid market just because you're scared that might happen in the future.

Comments

[jimmy smith:]

a lot of the private equity held companies will be zeros due to massive debt loads. therefor the collage endowments will be utterly crushed this year. i'm predicting they'll drop upwards of 60% on average.

one issue: due to the ill-liquidity of these (and others!, read: forests) how with the endowments market the losses? probably they'll attempt to hide them ("mark to whatever allows us to save face and maintain donations, administrator jobs and high salaries").

Feb 19 12:56 PM

[otbricki:]

PE is just going to offer less to keep their leverage down, that is all.

Feb 19 01:36 PM