Endowment and Foundation (E&F) Investment Committees often consider the value of alternatives for their nonprofit. Typically, there is an interest in the additional diversification alternatives may offer and the potential to increase return and manage risk. In this brief paper, we will touch on what we believe are some of the most important issues and questions—including the different types of assets, return potential, fees, liquidity, diversification, volatility and transparency—that investment committees must understand as they weigh adding alternatives to their portfolios. Importantly, this information should just be the start of a more in-depth conversation with an investment manager or advisor who would take into account the nuance and needs of each institution.
THE NEED
If you are reading this, you are probably well aware of the obligations that endowments and foundations have to meet both the current and future spending needs of their institution. We believe that the investment return needed to achieve that objective should be the most important guidepost for a portfolio’s asset allocation. There can be different paths to take depending on the specific circumstances of the organization. These can include aspects like size, time horizon, expertise, financial situation and governance.
Many committees may have experienced robust returns in their organization’s portfolios in recent years, but now recognize in looking ahead that the market opportunities may have shifted. Further, massive fiscal and monetary stimulus has triggered some inflationary forces, which if persistent at higher levels, could see equity and bond correlations trend higher and implied portfolio diversification between equities and bonds diminish. Alternative investments can play a role in achieving sustained diversification, as well as contributing to earning a rate of return consistent with spending needs.
Muted Expectations
Over past decades investors have had to take more risk in order to meet the same return hurdle. With traditional assets like stocks and bonds at high valuations, the implications for future returns of those assets may be underwhelming.
Source: BLOOMBERG. This analysis is not intended to be a guarantee of future results. It is not representative of an actual portfolio. Asset allocations could change depending on risk tolerance, investment objective and assets available for investment. The relationship team will customize portfolios to meet the guidelines, requirements and risk tolerance of our clients. The information provided in this is not intended to be and should not be considered to be a recommendation or suggestion to engage in or refrain from a particular investment strategy, including whether or not to buy, sell or hold investments in any asset class mentioned. It should not be assumed that investments in such asset classes have been or will be profitable. Estimated performance of the Brown Advisory proposed portfolio is based on the internal research of our Investment Solutions Group and Private Equity team. The estimated volatility is based on the historical volatility of the indexes presented and defined on the disclosures page at the end of this presentation. Estimated returns as of June 30, 2021. The estimated returns are representative of a hypothetical portfolio and asset allocation. Re-balancing is set at semiannual. This performance output does not include any cash flows in or out of the portfolio and past performance is not indicative of future results. Performance source: BLOOMBERG. Brown Advisory Analysis. Alternative Investments may only be available for accredited investors and/or qualifed purchasers. Please see the end of the presentation for important disclosures.
WHAT IS AN ALTERNATIVE ASSET?
The term “alternative” relates to many different types or styles of investing—but the common denominators are different investment structures and access, fees and liquidity. We segment alternatives into two broad categories: hedge funds and private investments. Hedge funds can include a number of strategies: long-short, trading-oriented, global macro, event-driven and activist. These examples are different approaches hedge funds can take in an effort to deliver diversified outcomes. Private investments include funds focused on buyout, venture, growth capital, real estate, private credit and energy/real assets. It can also refer to direct investments in privately held companies. Below is some context around what we consider to be the common types of alternative assets.
Long/Short Hedge Strategies: These strategies can help manage volatility over the course of a market cycle in an underlying asset class (equities, credit). For instance, long/short equity exposure seeks access to generate return through both long and short positions in companies. These strategies seek to provide lower volatility and long-term return potential through differentiated returns.
Buyout & Growth Capital: These sub-classes of private equity have the potential to offer meaningful growth opportunity due to the inefficiency of the private markets and the breadth of private investment opportunities. Strategies can include seeking to acquire and add value to existing enterprises and providing expansion capital.
Venture Capital: With many companies delaying initial public offerings until they reach relatively mature market capitalizations, venture investors often have the potential to reap the majority of the returns. With the potential for outsized returns, venture investing also bears enhanced risk. We focus on minimizing this enhanced risk by seeking to invest with leading venture managers that rank at the top of their peer groups – as well as what we believe to be promising emerging managers that offer the potential for outperformance. Often, we seek early-stage investments with managers that can capture a company’s growth from nascent to more mature.
Private Credit: Investors in search of cash flow can be rewarded in the private markets. However, not all private opportunities appropriately compensate investors for the risk they are taking in providing credit to small- and mid-sized businesses. We seek to partner with conservative managers that can produce meaningful yields in excess of public-market options, including high yield and syndicated loans.
At the portfolio level, we currently look at climate factors through three primary lenses: physical asset risk, carbon exposure, and participation in low carbon solutions to drive future cash flow. The “climate dashboard” on page 2 provides several different views of our sustainable model portfolio, as compared with its benchmark, the MSCI ACWI Index.
Private Real Estate: Our approach to investing in private real estate is organized into two categories, each with a distinct role in a client’s portfolio. The first category is focused on income-oriented real estate investments that have the potential to provide attractive cash flows throughout the holding period. This also has the potential to experience attractive risk-adjusted returns supported by both income and appreciation of the underlying real estate. The second category tends to involve real estate development or redevelopment projects. These types of investments can often have more private equity-like characteristics, such as longer-term time horizons and illiquidity as trade-offs for higher return potential.
- We believe a private investment portfolio should be diversified across the risk/return spectrum.
- Our preference is for clients to make programmatic commitments throughout a market cycle to help achieve diversification across vintages.
Mixing it Up
Balanced portfolios typically include a diversified allocation of private asset classes.
Source: Brown Advisory Analysis. This analysis is not intended to be a guarantee of future results. It is not representative of an actual portfolio. Asset allocations could change depending on risk tolerance, investment objective and assets available for investment. The relationship team will customize portfolios to meet the guidelines, requirements and risk tolerance of our clients. The information provided in this is not intended to be and should not be considered to be a recommendation or suggestion to engage in or refrain from a particular investment strategy, including whether or not to buy, sell or hold investments in any asset class mentioned. It should not be assumed that investments in such asset classes have been or will be profitable. Alternative investments may only be available for accredited investors and qualified purchasers. Please see the end of the presentation for important disclosures.
THE POTENTIAL REWARD
We believe alternatives can be a risk reducer and a return enhancer. This can be particularly important for organizations who rely on their investment programs to support operations and programs through distributions during favorable and unfavorable market environments.
While investing in alternatives may not be a quick or short-term decision, we do believe that the additional exposures gained from experienced and high quality managers across certain less efficient parts of the market can help organizations in meeting their return target. Another potential benefit can be lower volatility by way of the additional diversification that alternatives help deliver by reducing the drawdowns and crystallization of losses.
As shown in the exhibit below, for a qualified purchaser with a long-term time horizon and sufficient liquidity, having a partner with expertise in alternative investments can be a valuable option for helping to manage risks and improve outcomes.
To help achieve success, however, seeking to identify and access the best managers in each asset class is important given the dispersion of returns across various managers. We believe that a strong network of relationships and history with managers; a robust due diligence process for manager selection, sizing and term negotiation; and dedicated team members devoted to each asset class contributes to long-term results. When investing in alternatives, we seek long-term partnerships with portfolio managers and teams that possess specific talent and skill. Being able to find those managers who we believe are best positioned to continue to deliver strong results is both a quantitative and qualitative process that takes time and experience.
Many committees are also increasingly addressing how to align investments to their organization’s core missions. Alternative investments can play unique roles in helping to support these objectives. Examples that we have seen from our client work include investing in local affordable housing, environmental projects and innovative startups that are driving diversity, equity and inclusion among communities. These select alternative investments can deliver both attractive returns and impact over the long-term.
Possible Advantages of Alts
A hypothetical portfolio including alternative investments could have outperformed a portfolio without alternatives and have lower drawdowns over a long-term period.
Sources: Morningstar, HFR.com. Dates: 1/31/1995 to 9/30/2020. Hypothetical Portfolio with Alternatives includes: Equities 35%, Fixed Income 25%, Private Equity 15%, Real Estate 10%, Venture 5%, Hedge Funds 5%, Cash 5%. Hypothetical Portfolio without Alternatives: Equities 70%, Fixed Income 30%. The performance and portfolio presented herein is hypothetical and does not represent the investment performance or the actual accounts of any investors or any investment funds. The securities in the hypothetical portfolio were selected with the full benefit of hindsight, after their performance over the period shown was known. The results achieved in our simulations do not guarantee future investment results. The model performance information in this presentation is based on the back-tested performance of hypothetical investments over the time periods indicated. “Back-testing” is a process of objectively simulating historical investment returns by applying a set of rules for buying and selling securities, and other assets, backward in time, testing those rules, and hypothetically investing in the securities and other assets that are chosen. Back-testing is designed to allow investors to understand and evaluate certain strategies by seeing how they would have performed hypothetically during certain time periods. Past performance is not indicative of future results. Alternative investments may only be available for accredited investors and qualified purchasers. Please see the end of the presentation for important disclosures.
CONSIDERATIONS
As with any investment, returns should be considered net of fees. Often alternatives are more expensive due to the complexity and resources devoted to the strategy or the targeted illiquidity premium. Alternative investments can be worth a premium fee if the net-of-fee return is in sufficient excess to its closest alternative, and is contributing in a meaningful way to the portfolio’s long-term return objectives net of all other considerations (fees, liquidity, structural differences). We believe that making decisions based solely on fees misses the goal of meeting a return objective and thoughtfully managing risk long-term, but it must be considered in light of the desired outcome when compared to lower cost investment options.
Many private equity funds have a term life of ten years or more. This can mean liquidity is less available initially and comes later in the fund life from distributions when companies are sold or other types of liquidity events occur after the companies grow and mature. This fund life is intentional to give the manager time to grow the company through operating expertise and additional capital, which takes time. Hedge funds are semi-illiquid (e.g. monthly, quarterly or annual liquidity). Like private investments, the fund structure is intentional to be able to support more alignment with the underlying investment strategy and to be able to take a longer-term view on the investment opportunities.
Sizing is an important consideration, as too small of an allocation may be meaningless in a portfolio and tie-up capital unnecessarily or create over-diversification. Too large of an allocation may over concentrate a portfolio in a particular area or create undue liquidity risk. Many alternative strategies also call capital during dislocations in an effort to take advantage of attractive opportunities, which can add stress to an already painful situation if not properly modeled. Finally, in an effort to successfully invest in alternative investments over the long-term, an organization needs a disciplined due diligence process with asset class expertise to avoid investing in lower-quartile alternative managers. We believe this is fundamental to building a diversified asset allocation. Committees can augment their knowledge of these asset classes through constituent members and independent networks as well.
A Tale Of Haves And Have Nots
Access and manager selection are critical. The performance delta between topquartile and bottom-quartile managers helps highlight the importance of access and manager selection.
Source: Cambridge Associates Benchmark Data. Due to the illiquid nature of the investments, meaningful performance data may take several years to materialize. The funds need time to deploy capital and for the underlying investments to reflect meaningful performance. To allow for the meaningful performance to materialize, returns are often reported by industry organizations with delays. The chart to the right shows the upper quartile, median and lower quartile returns according to the Cambridge Associates U.S. Private Equity and Venture Capital benchmark from December 31, 2000 through December 31, 2017, which represents the most relevant recent data available. None of Brown Advisory’s private equity or venture capital funds are included in the data shown above. Brown Advisory data is not represented by Cambridge Associates benchmark data. The Cambridge Associates U.S. Venture Capital Index is based on data compiled from more than 1,800 institutional-quality venture capital funds. Past performance is not indicative of future results. Alternative investments may only be available for accredited investors and qualified purchasers. Please see the end of the presentation for important disclosures.
The bottom line is that alternative investments can be an important component to meeting the long-term return objectives of a portfolio. However, having experience or a partnership with an experienced team is critical to achieving the desired outcomes.
OUR APPROACH
When it comes to alternative investments, determining the right allocation across different asset classes, clarifying objectives, benchmarks and the role that each alternative asset will play in the portfolio is key, and is important to outline in the Investment Policy Statement.
With alternatives, we consider the following in assessing an investment manager’s ability to support the development of high quality private program customized to a specific nonprofit’s needs:
- Access to top-quartile managers
- Concentrated portfolios in high-conviction investments
- Exposure to both established and emerging managers
- Aligned fee arrangements
- Flexible portfolio structures (direct, feeder funds, fund-of-funds) to meet the specific client’s situation
- “Risk-for-risk” analysis to funding capital
- Liquidity management and a budget for allocating to private investments in a disciplined way
A multi-manager approach seeks to protect against the loss of capital by diversifying across managers, including leveraging access to established, proven and emerging firms to help support the return opportunity in the asset class.
Many managers we seek out are mindful of the size of their fund and generally closed to new investors. Having a history with these managers and strong relationships may support the ability to gain an allocation when capacity opens or there is a new vintage. The other side is the need to meet a manager’s minimums if it is a capacity constrained manager and will only accept certain “check sizes.” In these instances, if that check is too large for an endowment, the opportunity to combine with other investors through feeder funds or pooled vehicles can support an allocation along with appropriate diversification. This enables allocation across a targeted set of managers, for a smaller investment amount, and in private markets, vintage year diversification.
Brown Advisory traces its origins to the investment bank Alex. Brown, a preeminent growth investor responsible for taking marquee companies like Microsoft, Qualcomm and Starbucks public. These decades-long alumni relationships have been combined with a deep and dynamic investment team, dedicated operational due diligence resources, legal resources, transparent pricing and client-service personnel for seamless delivery. This breadth of experience in Alternatives has fostered long-standing relationships with top-tier alternative investment managers and emerging managers that may be difficult to access. In addition to access, being able to offer flexibility to meet client needs regarding structure and sizing of allocations is an area we have devoted meaningful resources to so that clients can allocate at a size that meets their diversification needs. We believe these capabilities are well positioned to help endowments and foundations meet their return requirements across market cycles. 
The views expressed are those of Brown Advisory as of the date referenced and are subject to change at any time based on market or other conditions. These views are not intended to be and should not be relied upon as investment advice and are not intended to be a forecast of future events or a guarantee of future results. Past performance is not a guarantee of future performance and you may not get back the amount invested.
The information provided in this material is not intended to be and should not be considered to be a recommendation or suggestion to engage in or refrain from a particular course of action or to make or hold a particular investment or pursue a particular investment strategy, including whether or not to buy, sell, or hold any of the securities mentioned. It should not be assumed that investments in such securities have been or will be profitable. To the extent specific securities are mentioned, they have been selected by the author on an objective basis to illustrate views expressed in the commentary and do not represent all of the securities purchased, sold or recommended for advisory clients. The information contained herein has been prepared from sources believed reliable but is not guaranteed by us as to its timeliness or accuracy, and is not a complete summary or statement of all available data. This piece is intended solely for our clients and prospective clients, is for informational purposes only, and is not individually tailored for or directed to any particular client or prospective client. Alternative investments may only be available for accredited investors and qualified purchasers. This confidential communication has been prepared solely as a preliminary document to provide information regarding Brown Advisory’s private equity and alternative platform and may not be used or reproduced for any other purpose. This document is not an offer to sell, nor a or solicitation of an offer to buy, an interest in any investment opportunity, and may not be used or relied upon in connection with any offer or solicitation with respect to any investment opportunity. Any offer or solicitation with respect to any investment opportunity, if made, will be made only pursuant to a Confidential Private Placement Memorandum (the “Memorandum”), Limited Partnership Agreement (as amended, restated and/or otherwise modified from time to time, the “Fund Agreement”) and the subscription agreement related thereto (the “Subscription Agreement” and collectively with the Memorandum and the Fund Agreement, the “Offering Materials”). The summaries in this document do not purport to be complete and are subject to and qualified in their entirety by reference to the Offering Materials pertaining to any investment opportunity, copies of which will be provided to each prospective investor upon request. Each prospective investor should review the Offering Materials with respect to any investment opportunity for complete information concerning the rights, privileges and obligations of investors. If any of the terms, conditions or other provisions of the Offering Materials relating to any investment opportunity are inconsistent with or contrary to the descriptions or terms in this document, such Offering Materials shall control. No person has been authorized to make any statement concerning any investment opportunity other than as set forth in the Memorandum pertaining to such investment opportunity and any statements, if made, may not be relied upon. The strategies and terms described herein are subject to change. Any past performance described herein is not an indication of future results. Private equity investments will be characterized by a high degree of risk, volatility and illiquidity due, among other things, to the nature of the investments. Investors should have the financial ability and willingness to accept the risks and lack of liquidity that are characteristic of the investments described in the Memorandum pertaining to an investment opportunity. Accordingly, investors should only invest in private equity investments if such investors are able to withstand a total loss of their investment. No assurance can be given that any such opportunity s investment objectives will be achieved or that investors will receive a return of any of their capital. Investors should pay particular attention to the risk factors described in the Memorandum pertaining to an investment opportunity. Investors should not construe the contents of this document as investment, legal, tax, regulatory, financial, accounting or other advice and this document is not intended to provide the sole basis for any evaluation of an investment. Net IRR is calculated net of the carried interest, management fees, organizational expenses and partnership expenses of the underlying private equity fund. For Brown Advisory performance, calculations are net of Brown Advisory partnership administrative fees, organizational expenses and partnership expenses, but gross of Brown Advisory account fees. Net IRR calculations are generated in eFront, the portfolio accounting software product used by Brown Advisory. IRR calculations measure cash flows, including capital contributions and distributions, since the date of inception of the Brown Advisory funds, as well as Remaining Value. Remaining values used to calculate Net IRR are unrealized. Calculations may utilize the most recently available information from underlying managers, including some manager-provided estimates where statements are not yet available. Volatility is a statistical measure of the dispersion of returns for a given security or market index. In most cases, the higher the volatility, the riskier the security. Volatility is often measured as either the standard deviation or variance between returns from that same security or market index. Drawdown is a peak-to-trough decline during a specific period for an investment, trading account, or fund. A drawdown is usually quoted as the percentage between the peak and the subsequent trough. Index Definitions for graphic on page 3: Equities: The S&P 500® Index represents the large-cap segment of the U.S. equity markets and consists of approximately 500 leading companies in leading industries of the U.S. economy. Criteria evaluated include: market capitalization, financial viability, liquidity, public float, sector representation, and corporate structure. An index constituent must also be considered a U.S. company. Standard & Poor’s, S&P, and S&P 500 are registered trademarks of Standard & Poor’s Financial Services LLC (“S&P”), a subsidiary of S&P Global Inc. Fixed Income: The Bloomberg Barclays Aggregate Bond Index is an unmanaged, market-value weighted index composed of taxable U.S. investment grade, fixed rate bond market securities, including government, government agency, corporate, asset-backed and mortgage-backed securities between one and 10 years. Private Equity: The Cambridge Associates LLC US Private Equity Index® is a horizon calculation based on data compiled from 1,468 US private equity funds (buyout, growth equity, private equity energy and subordinated capital funds), including fully liquidated partnerships, formed between 1986 and 2017. Venture Capital: The Cambridge Associates LLC US Venture Capital Index® is a horizon calculation based on data compiled from 1,807 US venture capital funds (1,161 early stage, 210 late & expansion stage, and 436 multi-stage funds), including fully liquidated partnerships, formed between 1981 and 2018. Real Estate: The FTSE Nareit All Equity REITs Index is a free-float adjusted, market capitalization-weighted index of U.S. equity REITs. Constituents of the index include all tax-qualified REITs with more than 50 percent of total assets in qualifying real estate assets other than mortgages secured by real property. Hedge Funds: The HFRI Asset Weighted Composite Index is a global, asset-weighted index comprised of single-manager funds that report to HFR Database. Constituent funds report monthly net of all fees performance in US Dollar and have a minimum of $50 Million under management or $10 Million under management and a twelve (12) month track record of active performance. The HFRI Asset Weighted Composite Index does not include Funds of Hedge Funds. The constituent funds of the HFRI Asset Weighted Composite Index are weighted according to the AUM reported by each fund for the prior month. Definitions of indices used for the “Portfolios Poised to Earn Long-Term Returns of 7%—Various Time Frames” table on page 1: Investment Grade Bonds - Bloomberg Barclays Aggregate Bond Index is an unmanaged, market-value weighted index composed of taxable U.S. investment grade, fixed rate bond market securities, including government, government agency, corporate, asset-backed and mortgage-backed securities between one and 10 years. High-Yield Credit - Bloomberg Barclays U.S. Corporate High Yield Index measures the market of USD-denominated, non-investment grade, fixed rate, taxable corporate bonds. Securities are classified as high yield if the middle rating of Moody’s, Fitch and S&P is Ba1/BB+/BB+ or below, excluding emerging market debt. Developed Markets - The MSCI ACWI ex USA® Index captures large and mid-cap representation across 22 of 23 Developed Markets (DM) countries (excluding the US) and 23 Emerging Markets (EM) countries*. With 1,856 constituents, the index covers approximately 85% of the global equity opportunity set outside the US. Emerging markets - The MSCI Emerging Markets® Index captures large and mid-cap representation across 23 Emerging Markets countries. With 834 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country. Private Equity - Cambridge Associates Fund of Funds Benchmark is based on data compiled from nearly 700 institutional-quality fund of funds. Real Estate - The FTSE NAREIT® Equity REIT Index is a broad-based free-float weighted index consisting of real estate investment trusts (REITs), calculated based on price and total return methodologies, both real time and end-of-day. The index contains all Equity REITs not designated as Timber REITs or Infrastructure REITs. FTSE is a registered trademark of the London Stock Exchange Group PLC (“LSE Group”). NAREIT® is a registered trademark of National Association of Real Estate Investment Trusts®. Hedge Funds - HFRI® Equity Hedge Index: Contains Investment Managers who maintain positions both long and short in primarily equity and equity derivative securities. A wide variety of investment processes can be employed to arrive at an investment decision, including both quantitative and fundamental techniques; strategies can be broadly diversified or narrowly focused on specific sectors and can range broadly in terms of levels of net exposure, leverage employed, holding period, concentrations of market capitalizations and valuation ranges of typical portfolios. EH managers would typically maintain at least 50% exposure to, and may in some cases be entirely invested in, equities, both long and short. Private Credit - Cliffwater Direct Lending Index (CDLI) seeks to measure the unlevered, gross of fee performance of U.S. middle market corporate loans, as represented by the asset-weighted performance of the underlying assets of Business Development Companies (BDCs), including both exchange-traded and unlisted BDCs, subject to certain eligibility requirements. The CDLI Total Return Index includes three components: Income Return, Realized Gain/Loss, and Unrealized Gain/Loss. It is not possible to invest directly in an Index. Bloomberg Barclays Indices are trademarks of Bloomberg or its licensors, including Barclays Bank PLC. MSCI indexes and products are trademarks and service marks of MSCI or its subsidiaries. © 2019 Hedge Fund Research, Inc. - All rights reserved. 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