Just seven years ago, more than 84 percent of Baylor’s endowment assets were in what is known as Level 3 assets, meaning they were illiquid and estimating their value required input that couldn’t be observed and reflected management assumptions.
Put another way, a percentage like that makes many financial analysts twitch. They may carry greater potential rewards but they’re generally much riskier, particularly if you need to cash them in quickly.
“The question is whether that’s what Baylor wanted,” said Joe Wright, senior vice president and chief investment officer for High Ground Advisors, an investment and trust-services company with nearly $2 billion in assets, previously known as the Baptist Foundation of Texas. “That percentage [84.6 percent in 2009] is well outside our range of comfort.”
At the end of the 2016 fiscal year that ended May 31, 2016, the percentage of Level 3 assets in Baylor’s portfolio was down to 44.8 percent, a figure that is much more in line with the averages of other endowments and non-profits.
“Private investments and illiquid hedge funds increased to a higher percentage of our endowment portfolio in 2009 than anticipated,” said Baylor Chief Investment Officer Dr. Brian Webb ’77, MBA ’79, who assumed his current role in June 2010. ”An endowment can handle a reasonable amount of illiquidity in its investment portfolio, but too high a concentration in Level 3 assets limits the ability to take advantage of near-term liquid opportunities and can force the sale of more liquid assets at inopportune times.”
Fixed Income and Public Equities are generally Level 1 assets, Hedge Funds can be Level 2 or Level 3 depending on the nature of their underlying investments, and Private Investments are generally Level 3. Other examples of Level 3 assets include certain privateequity investments, certain residential and commercial mortgage-related assets (including loans, securities, and derivatives), and long-dated or complex derivatives including certain foreign stock exchanges, foreign options, and long-dated options on gas and power. Level 3 assets trade infrequently so there are not many reliable market prices for them.
For comparison, a review of the portfolios of other private schools reveals distinct variations. Several of these other institutions have undergone similar, in some cases more successful, restructur-ing of assets in the same period of time. Princeton’s percentage of Level 3 assets in 2009 was 80.8 percent, but it now stands at 3.6 percent. At Duke, the 2009 percentage was 68.5 percent, but stood at 3.6 percent at the end of the most recent fiscal year. For Rice University in Hous-ton, the percentage has stayed in a fairly narrow band in the low 40s. And SMU’s current Level 3 percentage stands at 66.3 percent, demonstrating that there are many different investment philosophies among university endowment managers.
Webb does not see Baylor moving toward those lower levels.
“The sale of underperforming private investments in the secondary market post the financial crisis of 2008-2009 reduced our exposure to private investments,” he said. “Private investments are currently at 27% of our overall portfolio. Our measured pace of commitments to private funds is designed to stabilize private investments at our strategic target of 35% over the next 2-3 years. Level 3 assets in our portfolio are expected to increase somewhat over that 2-3 year period and then stabilize.”
Asked about the university’s long-range target for share of Level 3 assets, Webb said “50% is a good working number (on average over time), assum-ing our strategic target of 35% private investments remains in effect and exter-nal trusts remain at about 15%. That will leave us at the lower end of the range of diversified endowments greater than $1 billion in size.”
”At the depth of the financial crisis of 2008-2009, Baylor utilized Level 1 asset liquidity to support distributions to the University for scholarships and academic programs, and to cover capital calls from prior private-investment commitments,” said Webb. “Since that time, stress testing has been performed on our portfolio to ensure that improved liquidity of our hedge funds and better pacing of private investment commit-ments will provide sufficient liquidity to take advantage of pricing opportunities if another market correction of the mag-nitude of the financial crisis occurs.”
Webb said several factors caused the percentage of Level 3 assets in Baylor’s Endowment to increase after the finan-cial crisis of 2008-2009:
Public equity values declined more quickly and to a greater degree than private investments during the financial crisis driving the percentage of Level 3 assets higher.
A concentration of commitments to private investments made prior to the financial crisis were called after the financial crisis, adding further to the balance of Level 3 assets (private invest-ment funds typically have four years to call and invest committed capital).
Monthly distributions from the Endowment to the University for scholarships and in support of academic programs are made from Level 1 assets driving the percentage of Level 3 assets higher.
Hedge funds increased their expo-sure to illiquid investments leading up to the financial crisis, resulting in a higher percentage being classified as Level 3 assets after the financial crisis.
For foundations and other non- profits, the percentage of Level 3 assets can be inflated by assets managed by third-party Trusts established by donors. Webb said that’s the case for approximately 15 percent of Baylor’s endowment.
“While most of the investments in these Trusts are Level 1 assets and val-ues are reported on an ongoing basis to the University, we record them as Level 3 assets as their liquidity to the University is at the discretion of the Trust,” he said.
Webb said Baylor took several tactical actions to regain a satisfactory degree of liquidity in 2010 and beyond. To do this, the university:
• Stopped making new commitments to private investments for more than two years and has paced its commit-ments since then to avoid concen-trated capital calls like it had after the financial crisis.
• Listed and sold some under-per-forming private investments on the secondary market to reposition the portfolio for future growth.
• Initiated the termination of hedge funds with illiquid investments.
• Moved new hedge-fund invest-ments to funds with greater liquidity.
HighGround’s Wright said there are pros and cons of having a high percent-age of Level 3 assets in your portfolios.
“With these types of assets, you expect to earn an illiquidity return premium – probably in the range of 300 to 500 basis points – compared to publicly traded equity.” Wright said.
“For example, if you expect a 10 percent long-term return from public equity, you need to earn a 13 percent to 15 percent return from private equity investments to compensate for the illiquidity.”
Though these higher level assets are associated with higher levels of risk, there can be some benefits for those will-ing to take the odds.
“These kinds of illiquid investments do make some sense,” he added. “The investment horizon is perpetuity, and only a small percentage is needed to fund your annual distributions. It’s about your ability and willingness to take on risk.”
Webb said Baylor’s Investment Policy provides guidance on the level of risk in its endowment portfolio through specifying acceptable strategic allocations to the four asset classes: fixed income, public equities, hedge funds, and private investments.
“Private investments make up the vast majority of our Level 3 assets and they generally have a finite life of 10 years (a four-year investment period as discussed above, followed by a six-year period to manage and sell the investments),” he said. “Once a private investment portfolio is fully built out, distributions from funds at the back-end of their 10-year life should more than cover capital calls from more recent fund commitments still in their four-year investment period. Maintaining an appropriate pace of commitments to private investments is one of the things reported to and monitored by our investment committee on a regular basis.”
Webb said Baylor’s objective in investing in alternative asset classes is to optimize the long-term value of Baylor’s endowment portfolio.
“In 2002, Baylor’s Regents decided to bring management of the endowment in-house specifically to bring more alternatives into the portfolio,” he said. ‘½.dding alternative investments to an endowment portfolio has historically provided approximately one percent higher annual returns than a traditional stock/bond portfolio, and with more protection to downside risk. Baylor’s Endowment portfolio since management was brought to campus through fiscal year 2016 has provided an 8.6 percent average annual return compared to 8.o percent for a traditional 70 percent/30 percent stock/bond portfolio.”
Those figures are consistent with – and actually a couple of percentage points higher than – the published returns of similar investment profiles over a 14½-year period from January 2002 to June 2016.*
But Webb says he’s not able to provide a line of sight into the appreciation of those Level 3 assets vs. the university’s acquisition costs, explaining that “changes in accounting principles that introduced the concept of Level 1, 2 and 3 liquidity after the financial crisis (ASC 820) focused on market value reporting. The reporting of historic costs at the individual asset class level was not required and we have never tracked the aggregate cost of our Level 3 assets.”
And to those who might advise the university to focus on investing in places like the Dow, which has doubled in price over recent years, Webb has a simple response:
“Portfolios focused on domestic exposures to large-cap stocks might be attractive over certain periods of time, but are too limiting to sustain top performance over the long run,” he said. “The ability to take advantage of investment opportunities across the globe in public, alternative and private markets is an attribute that top performing endowments possess, and our objective is to maintain a portfolio that performs at a very high level – top 10 percent – over the long hauLWe strive to identify and partner with the best and brightest managers across the globe that provide us with the flexibility to adjust to changing market conditions in a timely fashion and balance the maximization of returns with our liquidity requirements.”
