Why meeting current spending need is not correct, rebalancing is correct? Could you give different view here…
The Elbe Society is an organization dedicated to documenting and preserving the pre-20th century artistic culture of eastern Germany. The work of the Elbe Society is supported entirely by the Elbe Society Endowment, which has a portfolio worth approximately €360 million. The portfolio’s current asset allocation approximately matches its model portfolio of 45% in publicly traded equities, 45% in investment-grade fixed-income securities, and 10% in publicly traded real estate investment trusts (REITs). The model portfolio was chosen using mean–variance optimization to meet a target real return (in excess of inflation) of 4% with minimum return volatility. Spending for each year is set at 4% of the average value of the portfolio over the previous three years. The portfolio must be rebalanced each year to be close to the model portfolio allocation.
Elias Neumann, chair of the board of trustees of the Elbe Society, which also oversees the endowment, is meeting with Luisa Zimmermann, chief investment officer of the endowment. Neumann begins by informing Zimmermann that the board would like the spending rate to be increased to 5% of the average portfolio value within two years. He recommends substituting a portion of the investment-grade fixed-income securities with a 25% allocation to private equity, noting that the resulting portfolio will have similar return volatility, improved diversification, and a higher expected return than the current portfolio. The trustees would like the other allocation and spending rules to remain the same.
Zimmermann responds that there are other risk considerations that must be examined when replacing fixed income with private equity. She makes three statements:
Statement 1 | The reported return volatility of investment-grade fixed income is likely more accurate than that of private equity. |
Statement 2 | The risk of not meeting long-term investment goals is higher for investment-grade fixed income than for private equity. |
Statement 3 | The reported correlation of investment-grade fixed income with public equity is likely less accurate than the reported correlation of private equity with public equity. |
Zimmermann tells Neumann, “As we move toward an increased allocation to alternative investments—particularly private assets—we may want to move away from our current traditional asset allocation approach to a risk-factor-based approach. Traditional approaches have the advantage of being easier to communicate relative to risk-factor-based approaches. However, traditional approaches often commingle assets with very different risk characteristics in the same asset classes, resulting in portfolios with the same asset allocation but very different risks. Unlike the traditional approach, systematic risk factors do equally well at explaining the risk and return patterns of public and private assets.”
Zimmermann, discussing liquidity with Neumann, tells him, “If the fund adds the private equity allocation you recommend, it will be infeasible to rebalance to our model allocation on an annual basis. However, because we will experience much higher returns from private equity than we’ve been getting from the fixed-income securities being replaced, we should have no problem increasing our current spending rate, as requested. If we experience an economic downturn, a private equity position improves our overall liquidity because privately held firms are subject to fewer market pressures than publicly traded ones.”
Q. In her discussion of liquidity issues, Zimmermann is most likely correct regarding:
A. annual portfolio rebalancing.
B. maintaining current spending levels.
C. the impact of an economic downturn.
A is correct. Private equity requires a long-term commitment of capital with very uncertain drawdowns of that commitment and return of invested capital. Early in the investment cycle, only a portion of the committed capital will be called by the general partner and the timing of future calls is uncertain. Later in the investment cycle, the timing of a fund’s sale of investments and return of capital to investors is uncertain. The investment itself is very illiquid (hard to sell in the secondary market); thus, rebalancing to a model allocation on an annual basis will be infeasible.
B is incorrect. Early in the private equity investment cycle, committed capital will be held in relatively liquid assets with lower expected returns to fund capital drawdowns that have uncertain timing. Further, little return will be realized from early-stage investments, particularly on the venture capital side of private equity. Also, bad investments tend to fail earlier than good investments succeed. Overall, private equity is subject to a J-curve, with low or even negative returns early on and high returns later on. For these reasons, the portfolio’s overall return will be lower in early years, reducing the endowment’s available spending according to its current spending rules and making it difficult to increase the spending rate in two years.
C is incorrect. In an economic downturn, capital calls for a newer private equity fund can accelerate because depressed market prices produce good investment opportunities precisely when the endowment portfolio’s public asset values are depressed. This can require either selling portfolio assets for negative returns to fund capital calls or abandoning the investment in private equity at a total loss. Further, in an economic downtown, the general partner of a more mature private equity fund will extend the fund’s life and avoid selling holdings at depressed prices, thereby reducing cash flows the endowment portfolio had anticipated.
So, increasing current spending level is not correct here because we all know private equity as an asset class takes significant longer time to realize retun than say fixed income or public equity in general.
Private equity committed capital takes time to be called upon and during that time its allotted assets are invested in liquid cash assets which have lower return. Moreover, even if all capital has been called it usually results in many companies failing than many companies succeeding very fast typically called the J-curve effect.
Now, since spending rate has to be increase in 2 years itself, adding private equity won’t necessarily lead to higher returns in the portfolio in such short span of time to help increase the spending level.