Can the endowment model work for smaller organizations?
Olympic athletes are an inspiring bunch. I'm reminded of this every two years when the news is dominated by stories about these dedicated athletes and the great lengths they go to just to participate in the games. Those favored for a medal also seem to be those who have the monetary resources and support systems in place to allow them to access the training, coaching, and equipment they need to reach their potential. Other athletes with equal amounts of talent also make it, but lack of resources can sometimes make the difference between standing on a podium and watching your teammate accept a medal from your seat in the crowd.
This unequal allocation of resources isn't isolated to Olympic athletes. In fact, I see this same type of disparity in the endowment space all the time. Smaller organizations with lots of talent, skill, and drive aren't able to access the types of investments nor dedicate the amount of resources to their investment program as large organizations can. And, just like it does with Olympic athletes, this creates a gap between the performance potential of those with high amounts of resources, and those without. To try to combat this, some smaller organizations have adopted the "endowment model" – used with great success by their larger counterparts.
Constraints of the endowment model
This model is characterized by high allocations to hedge funds, private capital, and dynamic management across other less traditional asset classes, accompanied with low allocations to core fixed income. The downside of this approach for smaller institutions, however, is that to be executed successfully, it requires internal skill, resources, and scale, which many smaller organizations just don't have the monetary or personnel resources to provide. Trying to replicate the endowment model without sufficient resources has led to portfolios with higher risk and lower potential returns, coupled with higher fees and implementation costs than you would see in a "typical" portfolio. In the end, the model that was supposed to help them be more competitive has turned into an anchor holding them down.
How has this happened? Let's take a look at one area of the portfolio to illustrate the resources needed vs. those available – the private capital allocation.
Private capital allocation: Problems a-plenty for smaller organizations
A large organization will typically diversify the private capital allocation within their endowment across several different asset types, including private equity buyouts, venture capital, natural resources, and private debt. And then within those strategies, they will further diversify themselves across regions, managers, and vintage year of investment. This requires allocations to be made to an extensive list of funds.
To do this well, large organizations need sufficient capital to access a wide array of high quality managers, staff resources dedicated to researching, selecting, and managing these managers and the resulting asset flows, and the insight necessary to identify and monitor the risks inherent in these types of investments. Contrast this with the resources a small to mid-sized endowment may have to dedicate to their private capital holdings. Their smaller asset size will limit the number of funds they can invest in and may either prohibit them from accessing top managers or increase the fees they have to pay for access. It may also cause smaller organizations to exceed their illiquidity tolerance or build a portfolio which lacks adequate diversification. And, once the portfolio is built, the amount of staff time it will take to manage the ongoing flows from these investments may exceed the staff resources the organization has to dedicate to that work, reducing their ability to add value to other parts of the investment portfolio. Plus, managing these types of assets requires complex risk systems and skilled resources to manage those systems – which is something most smaller organizations don't have access to. It's important to note that the challenges smaller organizations face when implementing this model aren't reserved for the private capital allocation alone. Rather, this is just one example of how the complexities of this model can be difficult for a smaller organization to implement.
What can smaller organizations do?
To be clear, I don't believe the endowment model is broken or dead. Rather, I believe it's merely been misused by organizations who don't fully understand the resources required to implement it effectively. I delve into this concept deeper in a paper I recently wrote, How non-profits can improve upon the endowment model and make it work for them.
Going back to the Olympics – there are many examples of athletes who earned a medal who didn't have an abundance of funding, resources, or support. However, they all found a way to achieve their goal using a different approach than their well-funded counterparts. I believe the same is true of the endowment model. There are definitely elements of this model that smaller organizations can incorporate into their investment portfolios to help them thrive in today's environment. They just have to find another way to do so.
No one ever said setting your sights on gold was easy.