In its annual report released earlier this month, the Yale Investments Office noted that while it aims to ensure fair partnerships with its external endowment managers, it does not always have the ability to alter typical partnership terms to Yale’s advantage.
This year’s report provided an overview of how the Investments Office typically negotiates fees with external managers, detailing the different norms of partnership in each type of asset in which University invests, and how the office works to negotiate terms that are better than these norms.
The report acknowledged that the University has limited abilities to influence the terms of certain investments, including those with private equity managers undertaking leveraged buyouts, and with venture capital firms investing in startups and early-stage companies in high technology industries.
“In some markets, Yale has little bargaining power,” the report read. “In the leveraged buyout and venture capital asset classes, where top-tier firms enjoy intense investor interest for limited fund capacity, Yale is not in a strong position to modify economic terms.”
Finance experts who argue that Yale and other institutional investors should refrain from using external managers who seek to outperform markets, also suggest that the vast majority of these managers often fail to deliver better-than-market returns, and charge fees that are far too high regardless of how they perform.
According to the office, terms that facilitate fair fund structures aligned with Yale’s incentives include the co-investment of managers in the investment vehicles they manage and the establishment of performance hurdles that prevent managers from charging a percentage of profits generated unless they secure previously agreed-upon levels of return. Additionally, the Investments Office seeks to ensure that the management fees charged by external managers remain in line with their costs and do not become an additional source of profit that drive a “wedge between the incentives of the investor and the manager.”
With its demanding negotiating stance, the office claimed that its partnerships with external investment managers are not only fair for the University, but also better than what other investors might be able to access. For instance, while hedge funds are thought to typically charge an annual 2 percent asset management fee and take one-fifth of the profits generated, the report also states that more than 95 percent of the money Yale has put in hedge funds is invested with managers who have fee structures “superior” to this standard arrangement.
However, in investing with managers undertaking leveraged buyouts and with venture capitalists working with startups, the office said it does not have much power to alter the terms demanded.
“Fee negotiations really depend on the leverage that the parties have. Hedge fund managers have not been producing tremendously attractive returns, they are not going to have much leverage to negotiate better fees,” said Andrew Lo ’80, a finance professor at the Massachusetts Institute of Technology. “On the other hand, very successful venture capital companies and private equity companies have produced very attractive returns, and will have much more negotiating power.”
A pioneer in the investment of endowment funds into private equity and venture capital, Yale began investing in the high technology industry through venture capital managers in 1976. According to the Yale Investments Office’s annual report for fiscal year 2015, one of the first investments the office made was in a startup named Dell Computer.
In recent years, the University has seen great success from these investments, earning about 13 percent annually over the past 20 years through its leveraged buyout program, and about 77 percent annually over the past 20 years through its venture capital investments. Last year’s report highlighted Yale’s investment in professional networking service LinkedIn, where an original $2.7 million investment generated $84.4 million of gains once the company went public in 2011.
According to William Jarvis ’77, executive director of the Commonfund Institute, an institutional investment consulting firm, a very small number of managers generate attractive returns in these asset classes. As a result, any institutional investor seeking to place money with these managers will not have much negotiating power when it comes to fee structures — even if they have longstanding relationships like Yale does.
“I thought it was very frank of Yale to say that despite having cultivated these relationships over many decades, even they have limited ability to negotiate terms with these managers,” Jarvis said. “You cannot simply walk up to a venture capital manager and give them your money to invest — their talent is a scarce commodity.”
Jarvis said that while Yale may not have much negotiating power in structuring the fees charged by these managers, the University nevertheless reaps the benefits of its long-term relationships by other means, including potentially obtaining a privileged look at new companies and new funds. Maintaining these kinds of relationships allows Yale to consistently generate market-beating returns and justifies the fees the University pays, he added.
“There are other kinds of currencies here in addition to the fees,” Jarvis said. “And most importantly, if you look at the performance of Yale’s investments with these managers, these are some very good returns.”