THE ENDOWMENT MODEL - PART II

LESSONS FROM BILL WALSH AND THE "WEST COAST OFFENSE"

If pursuing a unique approach is the true “ethos” of David Swensen’s original endowment model, how should one think about it today? Given that many novel ideas in one discipline are often derived from another (and since the NFL playoffs are upon us), it may be helpful to turn to a coaching legend who gained notoriety around the same time as Swensen.

BACKGROUND

When the 49ers hired Bill Walsh, the NFL's version of a simple stock/bond portfolio was a strong running game. The trouble was, with an undersized offensive line and no star running back, Walsh appeared to be at a major disadvantage. He saw it differently. According the recent book, Gridiron Genius,

“Instead of lamenting the fact that he had an undersized offensive line and little hope of generating a productive ground game, Walsh saw an opportunity. While most coaches would have set out to compile a roster that could run the ball more effectively, Walsh sought a less obvious solution -- if he couldn’t change his players, maybe he could change his system. The result was the advent of what would eventually be referred to as ‘The West Coast Offense’.”

By pursuing a unique strategy, Walsh would go on to upend the NFL winning over 100 games, six division titles, and three Super Bowls in the span of a decade.

Like-minded investors today could benefit from doing something similar. Namely, playing to their own strengths, leveraging their liquidity, and exploiting opportunities by balancing discipline with creativity.

PLAY TO YOUR STRENGTHS

A Strategy That Fits

By pursuing a unique strategy, Walsh gave himself a clear advantage – the ability to target a very different type of player. Look no further than Joe Montana.

On paper, Montana was far from elite. He was undersized, had average speed and below average arm strength. Yet, Walsh saw a franchise quarterback. Why? Because Walsh’s system favored toughness over size, quickness over speed, and accuracy over arm strength. Walsh applied this same logic when he drafted a wide receiver from Mississippi Valley State (Jerry Rice), a “tweener” running back from Nebraska (Roger Craig), and a converted tight end from Clemson (Dwight Clark). In a different system, these players may have never made it in the NFL. But under Walsh, they thrived, and so did the 49ers. 

Smaller investors are in a position to do something similar. While out-sized institutional portfolios like Yale must make very large investments in order to impact performance (typically $50-100 million at a minimum), smaller pools of capital can make more modest-sized ones. This provides a much wider spectrum of investments to choose from and enables investors to explore less efficient markets, identify managers earlier in their careers, scale into positions over time, and more easily reallocate capital within their portfolio, all while remaining more concentrated.

What it Takes to Win

The trouble for many investors is that even when they recognize their inherent advantages, they often make a subsequent mistake – chasing performance.

While investors like David Swensen have a track record of consistently identifying and investing with first quartile managers, doing so is becoming increasingly difficult. Public managers who spend time in the first quartile too often find themselves in the bottom two, while private managers’ past performance is becoming less persistent. The good news is investing with first quartile managers is not the only path to success.

Look no further than Howard Marks’ memo titled “The Route to Performance”. Marks highlights an investor whose equity portfolio outpaced the S&P 500 by a wide margin over nearly a decade-and-a-half despite never finishing a single calendar year in the first quartile. Not once. How is this possible? The investor explained,

“We never finished a year below the 47th percentile or above the 27th percentile. As a result, we were in the fourth percentile for the fourteen-year period as a whole."

Said another way, by remaining consistently in the second quartile, this investor’s portfolio ended up in very top of the first quartile over the longer-term.

The Right Strategy Coupled with Consistency

By seeking investments in less obvious places and emphasizing consistency, investors can dramatically increase their odds of finding their own versions of Montana, Rice, Craig, and Clark. In doing so, they also increase their chances of obtaining better terms and fees, more personal attention, greater transparency, and the capacity to grow with these managers. Most importantly, this should increase an investor's confidence in an investment’s role, while making them more comfortable holding it through difficult times and willing to add to it opportunistically. A true win-win, simply by playing to your strengths.

LEVERAGE YOUR LIQUIDITY AND FLEXIBILITY

In the 1970’s, nearly every NFL franchise tried to build their teams around running the ball. After all, if it worked in Pittsburgh and Dallas, it had to work elsewhere, right? Not exactly. The majority of these teams simply ended up becoming lesser versions of the Steelers and Cowboys.

Today, many investors are headed down a similar path. If committing more and more capital to private markets has worked well for Yale, Princeton, and other institutional investors, it has to work elsewhere, right? Time will tell, but historically more capital and higher valuations make it more difficult to generate the same level of return. As a result, at a time when investors are increasingly favoring illiquidity, could the path to future success reside in more liquidity? Could it be an investor's version of short and timely passing routes?

The "Liquidity Premium"

Liquidity provides the flexibility to adjust when priorities change, asset allocation targets are breached, spending draws are needed, and dislocations occur. On the flip side, illiquidity has helped generate stronger returns (aka the "illiquidity premium"). Historically, the key has been determining the right balance between flexibility and return. But, what happens if that excess return falls?

For decades, first and second quartile private investments have generated returns in excess of 4-5% above the public markets (often significantly higher). This premium more than compensated investors for locking up their capital and even a small allocation could materially impact performance. However, as is the case with any investment that attracts more capital and competition, returns have fallen over time.

GLOBAL PRIVATE EQUITY

Gross Pooled Multiple of Invested Capital (“MOIC”)

Bain Capital 2019 PE Report

As a result, in order to generate the same level of additional return, investors have needed to increase their allocations to illiquid investments. Look no further than Yale’s allocation over the past thirty years. 

YALE UNIVERSITY ENDOWMENT

Asset Allocation Over Time

https://investments.yale.edu/

The math is straightforward. A 10% allocation that generates 4.5% of alpha adds 45 basis points (0.45%) to a portfolio’s total return. However, if that alpha falls to 1-2%, a portfolio would have to double or triple its allocation to these investments to generate that same 45 basis points of excess return. Importantly, while 0.45% may not sound like a lot, if compounded for many years, the difference is very meaningful (e.g. likely in tens to hundreds of millions for Yale historically).

This said, despite lower potential returns going forward, private investments will likely continue playing an important role for a many investors, especially those willing and able to accept more illiquidity. Truly differentiated private investors can invest in unique parts of the capital markets, capture value earlier in a company’s life cycle, and more effectively unlock hidden value. However, due to the concerns highlighted earlier, the bar for these investments should be higher today. More importantly, once an investor moves forward with building an allocation to privates, they must remain committed because reversing course is prohibitively expensive. 

DISCIPLINE LEADS TO CREATIVITY

Armed with this information, how should someone willing to think differently invest?

The first instinct is to be creative and search for esoteric, off-the-run, and complex strategies. For some investors, this has been a successful strategy. The trouble is doing so is often contingent on sustained continuity (i.e. low turnover among the chief decision makers), highly dependent on an portfolio’s specific objectives (e.g. a family office’s dual goal of strong returns and support for the local community), and requires maintaining substantial back office, organizational, and accounting support. Therefore, for most investors, there is likely a better approach – one that instills discipline first and creativity second.

Walsh thrived on this concept. While creativity was a key component of the West Coast Offense, it was 100% contingent on mastering discipline first, especially at the quarterback position. As he said in a Harvard Business Review interview,

“Montana had to first master the discipline to know which receiver to throw to, when, and why. The team’s success depended on Joe’s ability to work within that framework. Consequently, the job of the coach was to use drills and repetition so that Joe developed almost automatic moves and decision-making ability.”

Mastering discipline was critical because it made things second nature. Once mastered, Walsh would then encourage Montana to lean on his instinctive and spontaneous side. This meant allowing Montana to “break loose” roughly 10-15% of the time, which would make a phenomenal difference in the outcome of games. 

The story for investors is no different. Being creative and “breaking loose” is often the key to generating alpha. The trouble is, if you do not have the disciplined portfolio construction behind it, doing so more often leads to outsized losses rather than gains.

THE RESULT

If playing to your strengths, leveraging your liquidity, and balancing discipline with creativity is akin to an investors "West Coast Offense", how might this strategy be applied today? While this is far from a definitive list, it represents a snapshot of potential considerations.

Discipline

Rebalance Religiously - Despite being one of investing’s core tenets, rebalancing is arguably still its most underappreciated. By simply rebalancing, an equity-centric portfolio with an allocation to high-quality, lower-correlated assets can perform in line with (or better than) a fully invested equity portfolio and with less risk. This said, this is often easier said than done due to investor behavior. The pattern is strikingly familiar: (a) When markets begin to fall, investors invariably expect them to fall further and hold off from rebalancing. (b) When markets decline further, investors being worrying about a potential recession and hold off from rebalancing again for fear of being “too early”. (c) Then, when a recession hits, investors often panic and consider selling instead of rebalancing. This pattern is natural, but also precisely why a strong rebalancing discipline is so important, and frankly the best antidote for our own worst behavioral instincts.

Calibrate within the Pendulum - If rebalancing is the most basic discipline in portfolio management, calibrating a portfolio is arguably the next. While each cycle is unique, they share common traits. The pattern typically goes something like this – As an expansion takes hold, investor sentiment improves, capital flows into risk assets, leverage and valuations rise, and investor discipline wanes. As a result, by calibrating a portfolio accordingly by leaning into “risk assets” during the early stages of a cycle and away during the later stages, investors can reduce risk and improve their chances for better long-term returns.

Generate Recurring Cash Flow - Insurance businesses generate recurring cash flows from their “float”, software businesses from their subscription model, and real estate investors from their properties’ net operating income. In each case, the results are profound. Simply having an asset that consistently generates cash flows creates the optionality and flexibility to reinvest, distribute, or retain capital depending on the circumstances. While we all know that total return is the primary objective, cash flow is more durable and solves a lot of behavioral issues as well. 

Creativity

Private Market Investing = Truly Long-Term

Situation:

It is well-known that investors today, private and public alike, have reduced their time horizons and holding periods dramatically. The pressures of doing so are hard to resist and seemingly coming from all directions. As a result, investors have strayed away from the purest and most powerful forms of compounding – buying and holding truly superior businesses for the long-term.

Alternative:

• Historically, the most logical way to generate alpha has been to look for investments in new and unique places. Today the answer might come from thinking in new and unique ways -- namely through truly committing to longer time horizons. 
• In a play on Jeff Bezos’s often-repeated line, Brent Beshore (founder and CEO of the private equity firm Adventur.es) recently tweeted that, “Your time horizon is my opportunity”. Bezos wasn’t kidding and neither is Beshore. At a time when many investors are raising larger funds, investing capital more quickly, and selling early winners to produce strong IRRs, Adventur.es has taken a different approach…a very different approach. Look no further than its most recent~$250 million fund that has a ten-year call period and an astounding 27-year life. The reason is simple. Terms like this enable a manager like Adventur.es to hold investments much longer, minimize the incentive to “flip businesses”, add impactful operational support geared towards a portfolio company’s long-term benefit, and compound capital over many years. Not only does this create an economic benefit for investors, it also makes Adventur.es a very attractive partner for small business owners, which should lead to more high quality deal flow and better terms.

Applying Private Equity Approach to Public Equities

Situation: At this year’s Berkshire Hathaway annual meeting, Warren Buffett and Charlie Munger were critical of private equity. Namely, they criticized the way private equity calculates returns, levies fees, employs leverage, prices investments, and locks up capital. However, in doing so, Buffett and Munger failed to acknowledge private equity's advantageous features. Namely, its lower turnover, focus on high cash flowing businesses, concentration, and the fact that its capital call features, longer lock up periods, and performance reporting tend to save investors from their own worst instincts. This said, it begs the question...why can’t an investor simply apply the positives associated with private market investing to the public markets?

Alternative:

• Look for public equity managers who view investing in public and private markets as philosophically indistinguishable. These investors target under the radar businesses that produce critical products/services, have economies of scale, high switching costs, multiple growth opportunities, and are managed by management teams that think long-term, hold significant equity interests, act opportunistically, and have a strong track record of capital allocation.
• Partner with public market managers willing to apply a private equity framework to public markets. As an example, a manager would call capital over three years to invest in publicly traded securities, maintain a two year “recycling period”, and a subsequent five-year hold period. If a manager wants to sell an investment within the five-year hold period, they must return the proceeds of the sale to investors. Since this type of fund would be 100% invested in public equities, it can be fully liquidated at the end of a decade, meaning the DPI will equal the TVPI.
• Report differently. In addition to time-weighted returns, include dollar-weighted and net multiple returns across all asset classes. Emphasize longer-term time horizons and eschew the quarterly performance derby. Treat dollar cost averaging and reinvested cash flows as “public market capital calls”. Take advantage of downturns by setting up a rules-based framework.

A Public Power Law

Situation: Successful venture capitalists (“VCs”) have historically generated strong returns through a “power law”. While VCs invest in a wide range of companies, performance is dictated by a few outsized winners in a relatively short period of time (roughly 2-4 companies out of 30-40 companies in a fund). While this power law is inextricably linked to venture capital, it also exists in the public markets, albeit in a different form. The difference is that instead of being characterized by rapid growth over short period of times, the power law in public markets is driven by sustained growth over very long periods of time. To see how, let’s look back to a different era.

In the late 1970’s and early 1980’s my grandmother bought a handful of stocks. Over the years, she occasionally added to her positions, but she never sold. The result? When she passed away a few years ago, her original 15-stock portfolio resembled a long-term venture capital portfolio. 3-4 were outsized winners, a handful roughly matched the S&P 500, and the rest underperformed to varying degrees. By leveraging time though, her handful of winners compounded to such a degree that they more than took care of the losers. The result was that she dramatically outperformed the S&P 500. Said another way, she created a VC-like power law through the power of patience. (For a reference point, while she did not invest in it and at the risk of highlighting one of the best public equity investments of all time, had you invested $1,000 in Apple in November of 2000 and held it through today, it would be worth $230,000...a 230x over twenty years. Others of note -- Sherwan Williams = 25x, Nike = 18x, Starbucks = 15x, Danaher = 12x, Progressive Insurance = 10x, Northrup Grumman = 8x. Interestingly as well is the fact that these companies represent six different business lines, not one is a tech company, and each had been public for at least five years prior to 2000.

Today, live-pricing, shortened time horizons, and an emphasis on diversification over concentration have nearly driven this “old school” approach into extinction. However, through a combination of patience, sounds analysis, and concentration, alpha in the public markets could be unlocked once again.        

Alternative

• Seek managers whose primary objective is compounding capital rather than focusing on style boxes, market capitalization's, or sectors. These types of managers aim to invest in companies when they are small, add to those that are executing, and ride these investments until they become significantly larger businesses.
• Partner with managers committed to low turnover (ideally single digit) and a willingness to let positions become outsized through capital appreciation. Preference for separately managed accounts, reasonable fees, and an ability to add capital to the manager opportunistically.
•  Added deference towards managers who have experience investing both taxable and non-taxable dollars. Doing both provides a unique lens: Managing taxable dollars forces an investor to have even higher conviction (since exiting positions are more costly due to the tax implications). They also tend to let their “winners run” more than their non-taxable brethren. On the flip side, non-taxable investing is a “purer” exercise and therefore unencumbered by non-investing related considerations. In other words, the primary decision variable is an investment’s potential return and opportunity cost. Both are experiences are valuable, but together they can be invaluable.
• Look for “co-invest” opportunities with public equity managers to increase position sizes in highest conviction names. Target 10-15 positions and scale into them over time.

A Different Take on Diversifiers

Situation: Historically, portfolio “diversifiers” have come in the form of low beta or negatively correlated strategies. In addition to fixed income, this has typically included hedge funds and other non-equity linked investments (including CTAs, macro, precious metals, etc.).

Alternative:

• Most investors employ these sorts of “diversifiers” because they behave differently than equities. The trouble is, behaving differently means they under-perform equities most of the time, can be very illiquid and hard to rebalance, are difficult to understand, and opaque. However, what if we look beyond these non-equity linked strategies? What if we are willing to consider assets with historically higher correlations to equities, but are extremely out-of-favor at a given point in time? This is undoubtedly unconventional because it requires adopting a different mindset and would often mean going through the counterintuitive exercise of investing in equities to diversify away from equities. How could it work? Look no further than energy stocks today.
• Since the 2007 market peak, the S&P 500 is up 160%. Since the 2009 bottom, it is up nearly 500%. Yet, over these two time periods, the energy sector is flat and up 85% respectively (the worst performing sector by 30% and 150% in each case). Today, many believe the situation for the energy sector is dire with oil prices more than 60% off the highs, investor disdain widespread, and it becoming an increasingly smaller percentage of the S&P 500 (4.2%). Interestingly though, this is precisely why investing in energy today is so attractive, especially as a diversifier. While the energy sector's fundamentals has certainly worsened since 2014, its public equity performance has likely been worse. Unless you believe that global energy consumption is going to fall meaningfully over the next 10-20 years, fossil fuels are going to represent a much smaller piece of the pie, and that energy companies will not respond accordingly if either actually happens, then the downside for the sector should be largely priced in after such a poor decade. Need more upside catalysts? Despite the rise of renewables and new reserve discoveries, global oil consumption alone has actually outpaced global production over the past five years, rig counts and capex levels are falling, OPEC is cutting its production levels, and the energy sector dividend yield is nearly two times that of the S&P 500 at 4.3% vs. 2.0% (i.e. you get paid to wait). Lastly, if inflation returns, energy is one of the few places an investor can hide out and shield themselves from rising prices. With fixed income yields so low, this is even more so the case today.

Managing Through a Downturn

Situation: Many investors like to hold “dry powder” to deploy during a downturn. The trouble is, this is one of investing’s biggest fallacies. On one hand, since markets tend to rise more often than they fall, holding cash creates a massive drag on performance (especially with rates so low). On the other hand, even if investors plan to deploy it, the reality is that they rarely do. Fear, a belief markets will retreat further, and an increased focus on capital preservation are three obvious reasons why investors remain on the sidelines.

But, what about all that dry powder tied to private equity? As Ben Carlson wrote about in a recent post, private equity funds may want to deploy that capital, but they often have an even harder time deploying it because doing so in the privates markets requires open capital markets, available financing, and willing sellers….all things that are often not on offer at these moments. These also tend to be the times when private equity managers are forced to focus on managing their existing portfolio companies and dealing with investors breathing down their necks.

Alternative:

• Seek public managers that will set up a draw down structure based on specific criteria (high yield spreads widening, valuations falling, etc.), will only charge on invested capital, and agree to offer liquidity after a defined return target is achieved or after a specific period of time.
• Set up a rules-based framework that mandates investing a defined percentage of the portfolio into specific parts of the public markets in the event of a market downturn. As an example, if the Russell 2000 drops by more than 10% and simultaneously lags the S&P 500 by 5%, mandate shifting a specific percentage from large to small cap U.S. equities.

THE GOAL LINE

There is no silver bullet for managing a portfolio. For institutions like Yale, staying the course is likely the best strategy. For others, if Bill Walsh is any indication, applying a unique strategy and framework crafted around your institution's, family's, or personal circumstances could be a more likely path to success.

“If we are all thinking the same way, no one is thinking”

– Bill Walsh

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“Active management strategies demand un-institutional behavior, creating a paradox that few can unravel. Establishing and maintaining an unconventional investment profile requires acceptance of uncomfortably idiosyncratic portfolios, which frequently appear downright imprudent in the eyes of conventional wisdom.”

- David Swensen