Patient Capital Victoria Ivashina and Josh Lerner Harvard Business School No end of challenges Public sector seems unlikely to have resources to address alone… 3 And even if they did… 4 Meanwhile, massive pools of long- term capital… • At end of 2019, 100 largest asset owners held $19 trillion: – 20 largest asset owners had $10.55 trillion • Many are looking for long-run returns over generations…. – Sovereign wealth funds. – Endowments. – Long-run pensions. 5 But experiences with long-term investing very mixed • Returns in aggregate from many classes of long-run alternatives have barely matched the public markets in recent years: – Despite greater risks and illiquidity • In many cases, investors have approached long-term investments in a stop-start pattern: – Jumping in when markets are hot and dropping out when returns decline. • In many cases, fund managers have done well for themselves, even as the individuals and institutions providing funding have suffered. 6 The case of venture capital • VCs have focused on an increasingly narrow slice of technologies: – Software-oriented businesses. – Reflects where they have made their money! • This is demonstrated with case studies on VC groups’ portfolios. • As well as in patent data: – In 2014 awards, the top 10 primary USPC classes represented 38% of all VC patents, as opposed to 25% for non-VC patents. – In 1994, the corresponding numbers were 22% and 16%. – Innovation in general has become more focused, but VC even more so! • Meanwhile, many “tough technologies” languish unfunded: – Cleantech, advanced materials, many slices of medicine… 7 Illustration: The Pandemic Fund • Kleiner Perkins raised in 2006 $200 million fund dedicated to "worldwide pandemic preparedness … with a focus on surveillance and detection, diagnostics, vaccines and drugs.” • Several companies playing important roles in COVID vaccine development were financed by fund: BioCryst, Breather, Juvaris, NovaMax, … • Partners also played key role in promoting creation of Federal BARDA agency. • But never raised another fund… – Weak performance and organizational challenges prompted a rethink. 8 This talk • Looks at challenges associated with a long term perspective from perspective of … – Asset owners. – Fund managers. • Discusses a few potential remedies. • More to read if you like it… 9 It’s not pretty: The RSA story • Retirement Systems of Alabama has been run David Bronner since 1973: – Sought to invest long-term, and benefit Alabama at same time. – But many disastrous bets: • $240 million into US Airways, filed for bankruptcy in 2004. • Broadcast media and newspapers. • And… 10 It’s not pretty (2) – $350 million investment in 2007 into a new railcar facility in Barton, Alabama, which promised to create 1,800 jobs. – Filed for bankruptcy in 2010 before any railcars were produced. – Pension needed to invest invested another $275 million to complete it. • Alabama in the bottom quartile of state pensions: – Assets over liabilities. – Ratio of state pension liabilities to state tax revenue. • Alabama Policy Institute indicates that payments to cover pension shortfalls are already the largest expenditure by the state after education and will rise sharply. 11 Key challenges • Measurement. • Incentives. • Governance. 12 Why is measurement so important? • Asset allocation – Ignoring market risk can lead to investments with greater or lower amounts of risk than the organization can accommodate. • Time horizon – Potential for mismatch between the time horizons of liabilities and the assets that investors are allowed to hold. • Compensation – Misalignment between the assessment of valuation and performance could encourage adoption of strategies that are not long-term. • Commitment to a long-term strategy – Excessive reporting provides a stream of short-term market information that may send confusing signals and reduce commitment to a long-term strategy. The challenge of compensation • Staff evaluation and compensation schemes may create incentives for the staff to act against the long- term interests of the organization. • Compensation linked to performance can provide an incentive to focus on short-term strategies. – Staff might not have the motivation to pursue long-term investment strategies that show returns only after they have left the organization. – Long-term institutions must develop a method to link compensation to performance in the more distant future. • Staff must also be protected from career risk issues that may arise due to negative short-term performance. 14 Case in point: The CPPIB comp contretemps May 29, 2009 15 Long-term investors also face governance challenges. • Commitment to strategy – The board must defend the investment strategy during market downturns. • Without strong commitment, a long-term strategy can be pressured to adjust to short-term trends. • The ideal board should give high-level direction without micromanaging the investment staff. – Overreaction to short-term fluctuations. • Short tenure can cause board members to have a shorter-term vision than the organization which they oversee. – Creates an incentive to focus on good performance in the short term. 16 Internal and external pressures need insulation! • Short-term volatility can bring pressure from politicians, the press, other stakeholders, or the firm’s own compensation scheme to revise the long-term strategy of the organization. • When major Danish pension fund ATP shifted to long-term strategy in 2015, also changed structure: – Board gave management the discretion to make large asset allocation decisions. – Investment decisions are also framed in terms of risk, encouraging staff to consistently evaluate underlying risk drivers. 17 Confidential and Proprietary 18 LP: Systemic Approach to Long-Term Investments Long-Term Governance Performance Incentives/ Measurement Tools Compensation Communication The Middle Ground: Measuring Performance Fundamental challenge: 1. Illiquidity/”Patient” nature of the asset class • Challenges of measurement • Chase after the “top quartile” 2. The fact that private assets represent only a fraction of LPs’ assets An example of continuous confusion: as statement that is narrowly correct, presented as universal truth 20 The Middle Ground: Measuring Performance Use of subscription lines to manage IRR: - 2017 ILPA Guidance recommends reporting net IRR with and without the use of facility - A problem that is easily solved by use of MOM (a.k.a. ROIC) Source: PEI, “How Big is the Impact of Credit Lines on Fund Performance Really?” September 4, 2019 21 The Middle Ground: Measuring Performance Credit Rating model: An impartial (nonprofit?) third party solution Fitch, Moody’s, and S&P: their mandate is to provide investors with reliable advice on the quality of various debt offerings No, we didn’t miss the rating agencies mistakes and legal battels over subprime-mortgage bonds 22 Compensation (Part 1) "It's not a fair fight when a bunch of public officials are listening to people who are paid for raising money," W. Buffett. 23 Compensation (Part 1) 24 Compensation (Part 2) Ownership Share of Founder and Non-Founder Senior Partners 25 Other core and fascinating developments • Emergence of Alt platforms • Steady and silent consolidation of the industry: GP stakes • Longer-term/perpetual structures • ESG • Secondary market • Evolution of direct & co-investments • Expansion into retail money (DC funds and beyond) 26 Historical Yield on 10-Year U.S. Treasury Bond, 1962-2020:Q1 • Fixed income, but not necessarily public fixed income, remains a compelling diversifier to public equities • However, its historical return profile had been eroded, triggering a systematic search for yield Source: Compiled from https://fred.stlouisfed.org Growth Multiple (x) 10 12 14 16 0 2 4 6 8 Note: The figure excludes countries with with only The figure excludes countries Note: one reported. fund Malaysia Italy AUM Brazil Alts 2017 as a multiple of 2008 level Allocation to - weighted weighted averages, funds with 10 years of data, 2008 Japan Growth multiples of % allocation to alts* South Africa respectively. * Excludes France and South Korea with growth multiples of 60.34x and 24.31x, 24.31x, and of 60.34x multiples growth with Korea and South France Excludes Australia Germany Value Ireland - > 2x weighted (within country) (within weighted country) averages (funds with 10 years of data) 10years (funds with Israel Sweden Switzerland < 1.5x < 1.5x and 2x Between Spain Hong Kong Iceland Finland UK US Netherlands Canada Austria Norway - 2017 Denmark Belgium Portugal Latvia Victoria Ivashina Josh Lerner Lovett-Learned Professor of Finance Jacob H. Schiff Professor of Investment Banking Harvard Business School Harvard Business School http://www.hbs.edu/vivashina http://www.hbs.edu/jlerner 29.