Patient Capital

Victoria Ivashina and Josh LernerHarvard Business School

No end of challenges

Public sector seems unlikely to have resources to address alone…

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And even if they did…

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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.

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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.

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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…

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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.

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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…

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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…

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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.

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Key challenges

• Measurement.• Incentives.• Governance.

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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.

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Case in point: The CPPIB comp contretemps

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May 29, 2009

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.

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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.

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Confidential and Proprietary 18

Long-Term Governance

Performance Measurement Tools

Incentives/ Compensation

Communication

LP: Systemic Approach to Long-Term Investments

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The Middle Ground: Measuring PerformanceFundamental 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

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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

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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

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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.

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Compensation (Part 1)

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Compensation (Part 2)Ownership Share of Founder and Non-Founder Senior Partners

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)

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Source: Compiled from https://fred.stlouisfed.org

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

> 2x Between 1.5x and 2x< 1.5x

*Excludes France and South Korea with growth multiples of 60.34x and 24.31x, respectively.

Growth multiples of % allocation to alts*AUM-weighted averages, funds with 10 years of data, 2008-2017

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Allocation to Alts 2017 as a multiple of 2008 levelValue-weighted (within country) averages

(funds with 10 years of data)

Note: The figure excludes countries with only one fund reported.

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Victoria IvashinaLovett-Learned Professor of FinanceHarvard Business Schoolhttp://www.hbs.edu/vivashina

Josh LernerJacob H. Schiff Professor of Investment BankingHarvard Business Schoolhttp://www.hbs.edu/jlerner