Cowen’s Capital Introduction Group has compiled information on what the endowment and foundation community is thinking about hedge funds and how best to invest in them.
The Cowen paper on the subject begins with the observation, drawn from Preqin, that at present US-based E&Fs with more than $750 million in assets under management have, on average, invested 18.7% of that in the hedge fund space. This investment is spread out among, on average, 14 managers.
There are a couple of reasons why hedge funds love having endowments and foundations as investors. First, they tend to have long time horizons compared to family offices, funds and funds, and they don't run for the exits during high volatility periods and helps fund managers maintain liquidity and an even keel when other investors are rushing the door.
Second, endowments and foundations act as seals of approval for other investors and institutions and high net worth individuals may follow them into the fold. This is especially true of the Ivy League endowments, such as the Yale University endowment where David Swensen worked his magic in the 1980s.
Drawdown Aversion and Due Diligence
Unfortunately for prospecting hedge funds, endowments and foundations can be a hard sell. They will typically add only one, maybe two, new hedge fund investments in a year, making competition stiff.
They must be picky because “the typical spend rate of an E&F to fund their operating budget or grantmaking is approximately 5%.” They look for capital preservation and they are drawdown-averse. As the report observes, 44% say they would not be willing to lose more than 5% of the value of their portfolio in any given year, and another 38% put the ceiling between a 5% and 10% drawdown.
Demonstrating low downside volatility is a must for any hedge fund looking for endowment or foundation dollars.
It also means that the due diligence process can be a long one, requiring patience. The process typically lasts between six and nine months, with the clock starting at the first meeting.
Investment committee boards typically meet only once per quarter, and the investment committee must sign off on any such allocation, a fact that dampers any ambition to speed things up.
The Direction of Movement
In the last two years endowments and foundations have tended towards smaller allocations to hedge funds. The average allocation to hedge funds by those $750 million-plus endowments and foundations was 20% two years ago. It is now 18.7%. Hedge funds are losing out to private equity, private credit and venture capital as endowments and foundations move towards less liquid strategies and seeking the premium that comes with a longer time horizon.
What is important for those who are looking for some portion of that 18.7% is that while endowments and foundations have reduced the number of to whom they allocate, the dollars allocated to each have risen.
Why the greater allocations? In addition to the move into less liquid assets: endowments and foundations are reacting to the relatively subdued returns for hedge funds as an asset class since the global financial crisis, and they are pushing back on what they see as excessive fees.
The Range of Hedge Fund Strategies
Which hedge fund strategies tend to be the most attractive to endowments and foundations?
Equity long/short dominates, but endowments and foundations who allocate to this strategy, also want other funds that are not correlated to equity long/short space. This may include some of the more esoteric strategies such as litigation financing, direct lending, or healthcare royalties.
Some endowments and foundations have recently allocated to quant strategies, which is a break from the past. In years past, the endowments and foundations focused almost entirely on fundamentals in strategy and traditionally trained portfolio managers in execution.