economics and finance for engineers february 6, 2009 presented by: william h. mclean, v.p. & cio...

ECONOMICS AND FINANCE

FOR ENGINEERS

February 6, 2009

Presented by:

William H. McLean, V.P. & CIO

Northwestern University

Investments 2

Agenda

Understanding the Endowment

Asset Allocation

Active Strategies

Hedge Funds

Private Investments

Investments 3

Management Structure

• Strategic Direction of Portfolio• Review Asset Allocation • Investment Policy• Oversight of manager hiring/firing

• Strategic and tactical issues for the portfolio

• Due Diligence process/manager selection

• Portfolio monitoring

Responsibility

Investment Committee

Investment Office

W. McLean, VP & CIO

Public AR PI Oper.

Investments 4

Long-Term Endowment Fund Spending RuleMarket Element = 30% weight(Average market value for last 12 months times

long-term target spending or 4.35%)

Spending Element = 70% weight

(Actual CPI + 1.51%)

Total $ (Millions)

$ Per Unit

% Change

% Year-end Market Value

1996 $55.2 3.62 + 3.1% 3.59%

1997 $60.4 3.73 + 3.0% 3.08%

1998 $70.3 4.17 +11.8% 3.53%

1999 $73.2 4.27 + 2.4% 3.01%

2000 $95.5 5.30 +24.1% 2.92%

2001 $117.2 6.22 +17.4% 3.93%

2002 $130.2 6.56 + 5.5% 4.67%

2003 $150.7 6.90 + 5.2% 4.77%

2004 $160.4 6.87 - 0.4% 4.37%

2005 $161.4 6.75 - 1.7% 3.75%

2006 $176.2 6.81 + 0.9% 3.39%

2007 $197.5 7.22 + 6.0% 3.10%

2008 $233.5 7.80 + 8.0% 3.36%

2009 $269.8 e 8.54 + 9.5% 4.57% e

Investments 5

Investment Objective

“Preserve purchasing power of Investments and provide a growing stream of Income for the University’s programs.”

or

Annual Total Return Spending + Inflation>=

Investments 6

Investment ObjectiveAnnual Total Return Spending + Inflation>

=As of December 31, 2008

1-year 3-year 5-year 10-year 15-year

Annual Total Return -21.2% 2.9% 7.9% 8.0% 9.5%

- Spending 4.1% 3.6% 3.7% 3.9% 3.8%

- Inflation -0.4% 2.0% 2.7% 2.5% 2.4%

= Above objective -24.91% -2.68% 1.55% 1.59% 3.31%

Investments 7

Endowment Growth (Through August 31, 2008)

Beginning Endowment Value (1992)

$956

Net Additions

$3,015

Appreciation$4,821

Spending-$1,850

Ending Endowment

ValueAugust, 2008

$6,942

Investments 8

Endowment Assets ($ in billions)

Source: Cambridge Associates

#10

Harvard University 43.9

Yale University 22.8

Stanford University 18.6

Princeton University 14.9

MIT Inv. Mgmt Company 10.3

DUMAC, LLC 7.4

University of Michigan 7.2

University of Notre Dame 7.1

Columbia University 6.7

Northwestern University 6.6

Cornell University 6.3

University of Chicago 6.0

University of Texas System 5.8

University of California 5.7

University of Pennsylvania 5.6

Emory University 5.0

Washington University (St. Louis) 4.7

University of Virginia Inv. Mgmt Co. 4.7

Rice University 4.1

Vanderbilt University 3.4

Dartmouth College 3.3

University of Southern California 3.0

Brown University 2.9

Johns Hopkins University 2.8

New York University 2.4

UNC Management Company Inc. 2.2

University of Pittsburgh 2.1

University of Washington 1.9

Ohio State University 1.8

University of Toronto 1.7

Investments 9

Agenda


Asset Allocation

Active Strategies

Hedge Funds

Private Investments

Investments 10

Long-Term Asset Allocation Process

• Establish risk and return expectations

• Establish constraints

• Propose target portfolio and ranges

• Compare target to peers

• Approval of new target and ranges

• Review of new asset class benchmarks

Investments 11

Conventional Asset Return/Risk Perspective

Investments 12

The Holy Grail of Investing:15 or more Good, Uncorrelated Return Streams

Investments 13

3.00%

4.00%

5.00%

6.00%

7.00%

8.00%

9.00%

10.00%

0.00% 5.00% 10.00% 15.00% 20.00% 25.00% 30.00%

Expected Risk

Private Equity

Market Hedged

Real Assets

Intl Equity

US Equity

Fixed Income

Current Holdings

Ex

pe

cte

d R

etu

rn

Unconstrained Frontier

Constrained Frontier

Asset allocation using purely quantitativemean-variance framework

Investments 14

0

5

10

15

20

25

30

35

40

45

50

1988 1990 1992 1994 1996 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Ass

et A

lloca

tion

(%)

19.5 Global ex U.S. Equity

13.5 U.S. Equity

27.3 Marketable Alt.

9.4 Total Bonds

22.3 Non-Marketable Alt.

7.8 Equity Real Estate

0.2 Cash

Asset Allocation (%) Trends

June 30, 1988 – June 30, 2008


0.72.92.93.7

11.0

33.4

45.3

Investments 15

Asset Allocation gets more difficult when dealing with multiple alternative asset classes

• Private Equity (Buyouts and Venture Capital)

– Illiquid assets not marked-to-market

– Long term (7+ years) investment horizon different than that of publicly traded securities

– Separate asset class, but with “beta” to market

– Volatility does not capture true risk

• Hedge Funds

– Artificially created asset class; collection of investment strategies that cover the breadth of asset classes

– Distribution of returns NOT normally distributed

Investments 16

NU Asset Allocation

Preliminary As of December 31, 2008

Actual Target Low Range High Range

US Equity 10.5% 14% 11% 17%

International Equity 12.5% 16% 13% 19%

Fixed Income 10.4% 10% 7% 13%

High Yield Credit 7.9% 5% 2% 8%

Absolute Return 15.9% 18% 14% 22%

Private Investments 24.9% 20% 16% 24%

Real Assets 18.7% 17% 13% 21%

Cash -0.7% 0%

Investments 17

Total Endowment Performance

Preliminary as of December 31, 2008

-9.8%

-21.0%

3.0%

8.0%

-10.3%

-20.2%

1.5%

5.5%

3 Months 12 Months 3 Years 5 Years

Northwestern Benchmark

Investments 18

NU vs. Cambridge Associates’ Colleges and Universities(September 30, 2008)

NU -11.2 7.9 12.0

Investments 19

University Peer Returns (As of June 30, 2008)1 Year 3 Year 5 Year



Harvard Mgmt Co. 17.61


DUMAC, LLC 17.44


MIT Inv. Mgmt Co. 16.57






Univ of Virginia Inv Mgm Co. 14.37



Rice University 13.65

Univ. of Southern California 13.28


Washington Univ.-St. Louis 11.78







DUMAC, LLC 6.15














Emory University -0.43

Univ. of Southern California -1.23

Washington Univ.-St. Louis -1.36

University of California -1.93

University of Pennsylvania -3.92


DUMAC, LLC 17.01

















Univ. of Southern California 10.65

Washington Univ.-St. Louis 10.24




Investments 20

Agenda


Asset Allocation

Active Strategies

Hedge Funds

Private Investments

Investments 22

Beta is pretty simple. What about “alpha”?

Right now, alpha comes from 3 places:

Alpha production on top of benchmark

Benchmark Return

Alpha of strategy

Residual beta of strategy (may be zero)

2) “Pure Alpha” sources: Hedge Funds

• The product is the alpha, with our without some residual market beta

Alpha and Beta are integrated in strategy

3) “Embedded Alpha” Sources: Private Investments• The alpha is inseparable from the beta, but dispersion

of returns among managers suggests that alpha exists and can be large

1) Traditional sources: Active Managers• Alpha is integrated into the product, but is

easily identifiable

Investments 23

Agenda


Asset Allocation

Active Strategies

Hedge Funds

Private Investments

Investments 25

Allocation to Alternatives

Investments 26

Hedge Funds are characterized by non-normal distributions of returns

Distribution of Returns - Hedge Funds vs. Stocks and BondsMonthly returns, May 1994-October 2003

0

5

10

15

20

25

30

35

40

-10% -9

%-8

%-7

%-6

%-5

%-4

%-3

%-2

%-1

% 0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

Mor

e

Monthly Return (%)

# o

f O

bse

rvat

ion

s

Hedge Fund Returns(NU net returns)

Stock Returns(S&P500)

Bond Returns(Lehman Aggregate)

Hedge Fund Returns: positively skewed, lower risk than stocks

Stock Returns: very risky, negatively skewed, in other words there is significant negative tail risk

Bond Returns: not very risky, and are slightly negatively skewed

Investments 27

Five Broad Hedge Fund Categories Encapsulate Many Distinct Strategies

L-S (Jones Model)L-S (Mkt Neutral)L-S (Short Bias)

Deep Value / CatalystCap Str Arb / DistressDistressed Active

Interest Rate Value Commod. Value Macro

Merger ArbStat Arb / Prs TradingEquity Deriv. Arb

Convertible Arb Fixed Income ArbMortgage Arb

Commodity Arb Multi-Strategy*

EQUITYCAPITAL

STRUCTURE / CREDIT

INTEREST RATES

COMMODITY MULTIPLE

VALUE

ARB

INSTRUMENT

ST

YL

E

*Note: Multi-Strategy managers implement subset of all other strategies across the broad categories (indicated by different colors), and allocate risk to the strategies in a proprietary manner.

LONG-SHORT EQUITY1

2 4

3

5

LONG-SHORT CAP STRUCTURE

RELATIVE VALUE STRATEGIES

GLOBAL VALUE

MULTI-STRATEGY*

Investments 28

Hedge Fund Risk Management

• Understand the strategies

• Understand the correlation among strategies

• Understand opportunity set of each strategy

• Set allocation to strategies appropriately

• Find the best managers to execute strategies, with strong emphasis on trust and integrity

Investments 29

Non Market Risks Associated with Hedge Funds

Large Variation Across Strategy• Limited History of Operations• Leverage• Tail Risk & Correlation Convergence• Liquidity & Concentration of Portfolio• Style Drift• Short Volatility• Organization & Back Office• Fraud

Investments 30

Agenda


Asset Allocation

Active Strategies

Hedge Funds

Private Investments

Investments 31

Buyouts Fundraising

U.S. Buyouts and Mezzanine Fundraising

$28$47

$70$49

$94

$58$46

$33

$73

$169

$226

$282

$205

0

50

100

150

200

250

300

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 YTD3Q 08

$ R

aise

d (

bill

ion

s)

Source: Buyouts

Investments 32

Venture Capital Fundraising

Source: NVCA

Venture Capital Fundraising

$24

$11

$4

$19

$28

$32

$35

$0

$10

$20

$30

$40

2002 2003 2004 2005 2006 2007 YTD 3Q08

$ in

bill

ions

100

150

200

250

Num

ber

of f

unds

Investments 33

Venture-backed Exits

Source: Venture Economics & NVCA

M&A

IPO0

50

100

150

200

250

300

350

400

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

# o

f M

&A

Exi

ts

0

50

100

150

200

250

300

# o

f IP

Os

Investments 34

Trends in Private Investments

• FASB 157• Denominator Effect/Quest for Liquidity• Secondary Transactions (LP and GP)• Tough Fundraising Market• Emerging Markets• Longer Holding Period• Shake-out in the system? Is the model broken?• Increased # of Investors in the Market• Difficult to Access Top Tier Managers

Investments 35

Private Investments: Emergence of Mega Funds

Prior to 2004 2004 -2006

Funds > $3.5bn 9 19

Funds > $6.0bn 3 10

Funds > $10bn 0 5*

* Includes funds scheduled to close/closed in 2006. Apollo, KKR, Bain, TPG, Blackstone.

Source: Willis Stein Partners

Investments 36

Nine of the ten largest deals occurred in 2005/2006

Highlighted deals represent Northwestern’s Exposure

AcquisitionDate

AnnouncedDeal

($ Billions) PE FirmsHCA (US) Jul 2006 $31.6 Bain, KKR,Merrill

RJR Nabisco (US) Oct 1988 $30.6 KKR

Kinder Morgan (US) May 2006 $22.0 Goldman, Carlyle, Riverstone

Albertsons (US) Jan 2006 $17.4 Cerberus, Blackacre, Lubert-Adler

TDC (Denmark) Nov 2005 $15.3 Apax, Blackstone, Providence, KKR, Permira

Hertz (US) Sep 2005 $15.0 CD&R, Carlyle, Merrill

GMAC (US) Apr 2006 $14.0 Cerberus, Citigroup, Blackacre

Univision (US) Jun 2006 $12.3 MDP, Providence, TPG, TH Lee

Sungard (US) Mar 2005 $11.4 Bain, Blackstone, Goldman, KKR, Providence, TPG, Silver Lake

VNU (Denmark) Jan 2006 $11.0 KKR, TH Lee, Carlyle, Hellman & Friedman

Investments 37

GP Management Company Sales

• Retention tool or cashing out?

General Partners Amount AcquirorNatural Gas Partners 40% BarclaysAvenue Capital 20% Morgan StanleyFortress Investment Group 25% Nomura (15%); IPO (10%)Lansdowne 20% Morgan StanleyOspraie 20% Lehman BrothersSilverlake 9.9% CalpersBlackstone $3bn China

Investments 38

NU Alternatives Portfolio

• Investment program began in 1993• Four managers oversee the program• Currently represents 50% of the total endowment

– Includes hedge funds, buyout, venture capital partnerships, real estate, energy and a Co-investment program

• Mature portfolio but with opportunities to diversify• Long term investor mindset

Investments 39

NU Private Investments Portfolio

• Currently represents 20% of the total endowment– Includes buyout, venture capital partnerships, Co-

investment program

$ Millions # of Mgrs # of Funds Committed Called UncalledPE Domestic 26 58 $1,101 $843 $258Venture Capital - Domestic 33 83 $950 $640 $310PE International 16 27 $448 $254 $194Venture Capital - Intl 9 19 $167 $88 $79Coinvestments 16 NA $67 $42 $25Totals 100 187 $2,733 $1,867 $866

Investments 40

The Investment Process

1. Review Private Placement Memorandum and have initial meeting with GP

2. Follow-up meetings3. Due diligence4. Investment Memorandum5. Negotiation of terms 6. Receive Approval from Investment Committee/

Closing7. Monitor performance, build relationship

Investments 41

Due Diligence

1. Strategy

2. Management Team

3. Performance

4. Terms

Investments 42

Strategy

• Consistency across funds

• Differentiated in the marketplace

• Fund size supports strategy

• Deal sourcing ability

• Deal structuring– Purchase price multiple, leverage, management

ownership

• Ability to exit in various markets

Investments 43

Management Team

• Background

• Cohesion – Tenure of the team? Stable partnership?

• Carried Interest allocation within team

• Deal and board capacity

• Motivation of team

• Reference checks

Investments 44

Performance

• Realized deals– Source of realization: disposal, dividend, recap

– Dispersion of returns

• Unrealized deals– Current valuation method: 3rd party, EBITDA multiple at

purchase vs. market, public shares

• Deal attribution by partners• Source of value creation• Gross IRR/Multiples v. Net IRR/Multiples

Investments 45

Terms

• Management fee

• Carried interest

• GP commitment

• Key man provision

• Clawback (guarantee)

• No fault divorce clause

• Transaction fees, director fees offset

Questions

economics and finance for engineers february 6, 2009 presented by: william h. mclean, v.p. & cio...

Documents