E314: How Endowments Actually Think About Risk

0:00David Weisburd:You spent many years at the Cornell Endowment managing two and a half billion dollars at the time and generating some pretty spectacular results. What did that teach you about investing?

0:09Roger Vincent:I was at the Cornell Endowment for about 12 years. I left in 2024, so I got to invest there throughout an extended cycle, through a cycle. What I really learned about that experience was how important portfolio construction is to investment returns. And I think it's an area that people have under-invested in, under-spent time thinking about. And there's just a lot of value that investors can get by focusing on how they construct the portfolio that their asset classes are made of.

0:42David Weisburd:Why is portfolio construction such an underrated thing?

0:46Roger Vincent:Just taking the one asset class that I really spent my time on, which is private equity, which we think of as everything from early stage venture capital to growth equity to buyouts around the world, there's an incredible diversity of ways to generate the types of returns that are attractive to us as investors. And how you put those together in a way where the whole is more than the sum of the parts is really critical.

1:12David Weisburd:What are some examples of some assets that play a very specific role that complement the rest of private equity portfolios?

1:21Roger Vincent:Venture capital is a great example. Over long time horizons, venture capital has produced the best returns. And that's at the median level. It also has produced the best opportunity for outperformance by selecting first quartile managers. But it does this with a lot of cyclicality. And so if you make an entire portfolio out of nothing but venture capital, it may have characteristics in terms of highs and lows and lack of cash distributions that aren't tolerable for most asset owners. The most common misnomer is that you either have to sacrifice returns to get diversification that protects you from uncertainty to come.

2:06Roger Vincent:And so I tend to find that most investors feel like there's a trade-off there. If they want to generate high returns, they need to be highly concentrated and take all the risk associated with that. And if they want to de-risk and be more broadly exposed, that comes at the expense of higher returns.

2:26David Weisburd:Last time we chatted, we had this interesting conversation about the public markets. And exposure to beta has more or less become a zero-cost basis with index funds and ETFs. But that hasn't happened in the private markets. Why is that?

2:39Roger Vincent:Why didn't the private equity industry keep up with the times? It's hard to say. There are a lot of examples in financial markets of fee structures being a lot stickier than people think they should be. I would guess that in private equity, one of the reasons is it's been somewhat insulated from competitive pressures because of this large secular growth that we've seen in the asset class. And so as it's gone from this very niche part of the market to this very significant part of complex, large institutional portfolios, that growth has led to demand for products that probably has enabled people to survive with stale fee structures.

3:22David Weisburd:There's this constant product innovation. People are willing to pay for new products. Professor Steve Kaplan has done numerous studies on this, that private equity buyout and venture capital has alpha roughly three to 500 basis points net of fees. So the whole argument from the GP side is, yes, you're paying a lot, but you're actually on a net basis. You're still getting your 300 to 500 basis points a year. One of the hardest things of investing is seeing what's shifting before everyone else does. For decades, only the largest hedge funds could afford extensive channel research programs to spot inflection points before earnings.

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5:10Roger Vincent:You know, Professor Kaplan's work has been incredibly influential in the endowment world. It was influential on how I thought about investing at Cornell. How he measures out performance has really become the industry standard and has been a great new tool that we've had at our disposal. And so, yes, the industry does, on average, generate alpha. That doesn't mean that people should be paying for the part of the returns that is not the alpha, and that's the beta.

5:39David Weisburd:One of the interesting things about the allocator world is the incentives for allocators. Tell me about what those incentives are and maybe how they sometimes diverge with the underlying pool of capital.

5:53Roger Vincent:Incentives are incredibly important. I often say if there's only one word that one needs to describe my style of investor or what I think is the most important word in investing, it's alignment. And so how you set up incentives either creates that alignment or creates that misalignment. And I'm just going to be a little bit more specific. Anybody who invests in private equity who's not a GP is allocating. And so that allocator might be an endowment. That allocator might be a fund of funds. That allocator might be a high net worth individual that's picking funds themselves or picking direct investments themselves.

6:29Roger Vincent:They're allocating on their own behalf. They're both the asset owner and the allocator. So endowments are really interesting because they've been allocating to private equity probably as a group longer than just about any other group of asset owners. And they've been doing it in a greater scale. I would say they've achieved greater sophistication than anybody else. And one of the things that the endowment allocators have done, which is really unique and impactful, is they've set up better alignment with their allocation teams. In my experience, certainly at Cornell, but also knowing how many and my peers operate, the way they incentivize the team is relative to benchmark performance.

7:14Roger Vincent:And so their view is that everybody should be accountable to a benchmark of what one would expect to achieve in their asset class. You know, typically this is an investable passive way of accessing something quite similar. And that the only real value that that allocation team is bringing is outperformance over that benchmark.

7:37David Weisburd:Do you think that's the right way to approach it? Shouldn't it make sense to benchmark private equity against other private equity funds? Why benchmark against public indices?

7:46Roger Vincent:Well, the deeper answer is we're going to evaluate performance of a private equity portfolio about 25 different ways. And we're going to use each one of those evaluations for a different purpose. So yes, we are evaluating the performance of the private equity portfolio against other private portfolios. We're assessing each individual fund against other individual funds of their same style in vintage year and a core tiling exercise. But for compensation, the philosophy is that you want to pick something that represents your cost of capital. And most endowments are really just very sophisticated 60-40 portfolios, where about 60 % of the allocation is to equity exposure.

8:32Roger Vincent:And if the team weren't there and they wanted to run essentially the same portfolio, they would just put that 60 points in liquid passive beta. And so the active choice that is being made by the asset owner, the institution, is to go hire a bunch of allocators, have them take what was a passive and liquid asset, make it active and illiquid, and in that hope to generate excess performance.

9:01David Weisburd:How do endowments like Cornell and other IVs leverage co-investments to their advantage?

9:07Roger Vincent:You see a number of institutions, but certainly not all, applying some level of co-investment to their portfolios. And this could be direct investments or co-investments alongside an existing manager. Where I will tell you the industry really is, is that the most sophisticated investors are doing some level of co-investing with their existing managers to average down that fee load. And so rather than the industry coming off the two and 20 fee structure and saying maybe today it should be one and a half and 15, it's really, for the most part, sticking to two and 20, but allowing its larger, more sophisticated investors to achieve an all in lower fee burden if they take the time and the effort to go and co-invest.

9:55Roger Vincent:So there's a lot of people out there that are paying, you know, rack rate and then a number of more sophisticated players out there that are using this tool to to average those fees down. And so it's a really great tool to have. Some people are probably taking it a little too far. And, you know, the question I would ask them is, are you really, you know, the best investor in the world in all of these different little pockets of the market such that you can go and eliminate that fee by doing it yourself? Or are you going to be better off working with the world's best investor in that area and paying them the fees?

10:33Roger Vincent:And we were able to generate significant outperformance at Cornell, predominantly just working with the people that we thought were the best investors in that market.

10:44David Weisburd:I've spoken with hundreds of family offices that tried to do direct, maybe a couple hundred. A couple edge cases have worked. Almost all have failed. In other words, what's worse than two and 20 is paying 100 % of your investment into mistakes. The couple that have worked have very much stuck to their knitting. They had a manufacturing company. They would do direct investing into manufacturing plants. They had an oil rig. They would direct invest into oil rigs. In a case where they could not only assess, but they had the right to win against other private equity funds and other pools of capital in that very much category.

11:19David Weisburd:That's the only case that I've seen that has worked over time.

11:23Roger Vincent:That completely makes sense to me. I could see that people, if they really had an area of expertise, could invest there successfully. the problem is that most people don't have expertise in everything. And so if that's your only strategy of investing, you're going to have very poor diversification. And so I think of there as being a spectrum that people can be on depending on what kind of return they're trying to achieve. If you are an endowment, let's just say you're in the rich category, we want to stay rich category. And so the strategy that the endowments are following is designed to get the highest expected return with the lowest variance of potential outcomes.

12:09Roger Vincent:And so the diversification, the portfolio construction that we engage in is intended to do this, to increase the expected returns, but to constrain both tails, but particularly the left tail. At the full other extreme, if you want to make money, you know, the best way to do this is to be concentrated. And it's no surprise that the richest people in the world are the entrepreneurs who make all of their money by investing in a single company.

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14:52Roger Vincent:And so the vast majority of asset owners don't have the risk tolerance to go and be entrepreneurs or they've already been an entrepreneur. They've made their money that way. And now there's somewhere along this spectrum where they maybe have some tolerance for concentrated risk to keep growing that wealth. But they probably have some portion of their wealth that they want to make sure is being managed in the more endowment style where they're getting the best return possible, but really keeping a very careful eye on risks that can be diversified in a way.

15:25David Weisburd:And co-investment is an art in and of itself. I'd argue it's a little bit easier in buyout than venture capital. How does one become an elite co-investor when it comes to investing into venture capital co-invest?

15:40Roger Vincent:That's a really interesting question. The perspective I bring on it is before I was at Cornell, I was a GP. And so I've actually spent the majority of my career still at this point, having served as a GP, doing deals, syndicating, co-invest. And so I understand quite a few of the things that GPs are thinking about when they are syndicating something. And there's a lot of value that the co-investor can bring to the table other than the capital. And one of them is certainty and clarity and predictability. And so when we co-invest, we have a process that we think is rigorous, but very easy for the GP to work with.

16:26Roger Vincent:And so a problem a lot of family offices have is they're under-resourced and maybe they're new to this and they're not as easy to be capital partners with from the perspective of the GP. Your question on venture capital is a difficult problem for anybody to solve. The thing about venture capital is there's just a very big difference between early-stage venture capital and late-stage venture capital, just to pick two extremes. And most of the co-investing that one will see in venture capital is going to be at the late stage. That's when big dollars are being raised. And so nobody's going out and syndicating a seed or a pre-seed investment opportunity because the check is already very small.

17:10Roger Vincent:And so one of the problems which people have if they want to co-invest in venture capital is that they have to think about what stage they're going to get exposure to relative to what stage they're trying to get exposure to. And so there's that challenge. The other challenge is the power law. I think at this point, everybody really understands that there's a very long right tail to venture capital returns. And if you don't happen to have exposure to a piece of that right tail, the expected return in venture capital can be very low. And so again, this comes down to portfolio construction, you have to make sure that you are making enough co-investments and you're getting enough venture capital exposure that something is very likely to be in that right tail.

17:59Roger Vincent:You're going to have a big winner in there. So being able to do this at a very high volume is critical to getting the returns that you're hoping to get.

18:11David Weisburd:In that vein, you might have two investments. One, your foot is an ice hot water 10x. The other one is ice cold. It's a zero. On average, you should feel like it's a 5x, but it feels either very cold or very hot. Are there structural ways that institutional investors get around the variance of co-investments? And what are some best practices for that?

18:34Roger Vincent:You're bringing up a great broader topic, which is behavioral finance. And I think that the institutional approach that I learned at Cornell really tries to take some of the emotion out of private equity. And so one approach that most endowments are following, certainly I follow, is to be more systematic about your co-investing. And we're trying to build a larger portfolio of co-investments. We're really trying to capture that 600 basis points of fee saving without introducing additional risk into the portfolio. And so if you only do this once, you're introducing a lot of risk. the situation is fairly binary.