Although endowments and foundations have benefited from double-digit returns in recent years, many are reassessing the drivers of past portfolio returns and are looking to make mid-cycle changes.
Faced with a more challenging return environment, nonprofit organizations are looking to preserve returns in a rising-rate environment, seeking alpha by investing in less-liquid long-term opportunities, and turning to strategic partners to assist them in managing risk.
Endowments and foundations are finding interesting niche opportunities across a number of investments:
Private equity (PE) opportunities outside the U.S. are likely to generate strong returns, particularly in regions such as India and China where "dry powder" continues to grow.
Infrastructure and commercial real estate offer attractive opportunities, helped by favorable supply-and-demand dynamics and strong appetite for long-term assets.
Within fixed income, benchmark agnostic and absolute-return strategies can help nonprofit organizations maintain liquidity and generate higher returns than more-benchmark-oriented managers
Meanwhile, regulatory changes, such as the American Jobs Act and Volcker rule, are creating opportunities in private credit for private investors to fill the lending gap with attractive terms.
Endowments and foundations generated low-double-digit returns in fiscal year 2014 as a result of strong U.S. public equity markets and a shift to alternatives and longer-lived investments. However, as volatility and interest rates increase and global macroeconomic and financial cycles start to normalize, institutional investors will need to adapt to the changing market environment. In this article, Monica Issar
, Global Head, J.P. Morgan Endowments & Foundations Group
, and Anthony Werley
, Chief Strategist, J.P. Morgan Endowments & Foundations Group
, highlight the key trends in nonprofit investment management, as well as areas of opportunity for investors.
Endowments and foundations experienced strong returns in 2014
In recent years, endowments and foundations have generated strong returns, driven by venture capital, domestic and international equity, and private equity. Endowments posted average returns of 15.5% for fiscal year 2014, up from 11.7% in the previous year, according to the 2014 NACUBO-Commonfund Study of Endowments. Over the past 12 years, endowments have roughly doubled their allocation to less liquid and longer- term investments—assets with the potential to generate enhanced returns—to 51% in 2014 from 25% in 2002, while reducing their exposure to asset classes that have largely generated performance from beta (EXHIBIT 1).
Exhibit 1 Endowments have increased their allocations to private equity, hedge funds and real estate
Investment drivers are evolving in the current environment
Although most endowments and foundations benefited from double-digit equity returns in 2014, the outlook for future returns is more muted due to a paucity of readily evident market opportunities.
Our work with clients has presented three trends that are driving investment decisions for endowments and foundations in the current environment:
In a lower-return public equity environment, investors will need to shift from beta-oriented strategies to more intelligently sourced alpha in the public and private markets.
Nonprofit organizations are managing multiple objectives in the face of industry pressures. Many nonprofits are increasingly focused on risk—including pension liabilities, meeting target returns and managing short-term liquidity—with limited resources and are turning to strategic partners to help them navigate these challenges.
Institutions are actively restructuring their risk management, specifically in fixed income, toward more return-oriented strategies.
From a macroeconomic perspective, the global economic and financial cycles have moved beyond the recovery phase into a normalization phase wherein asset values are fairly priced, if not slightly expensive. In the bond market, normalization is represented by a tug-of-war between economic/market normalization and the impact of public policy quantitative easing around the world, particularly in Japan and the eurozone. Meanwhile, as investors move to strategies with the potential for higher alpha, primarily in alternative asset classes, there may be pockets of relative value in areas where normalization has not yet been achieved. Finally, the shifting market environment may provide opportunities for nonprofits to invest in structural dislocations, such as Europe’s demand for long-term assets like infrastructure.
In 2014, private equity was one of the strongest drivers of returns for endowments. From our perspective, over the long term, private equity offers significant opportunity for return enhancement for endowments and foundations when compared with public assets. Strategic corporate buyers are willing to pay higher prices in PE transactions to augment existing operations or platforms in their existing businesses, in the hope of ultimately generating greater brand value (EXHIBIT 2). Meanwhile, a high degree of purchasing power in the form of "dry powder" remains on companies' balance sheets in addition to financial sponsor purchasing power (EXHIBITS 3A and 3B). Unless there is a set of material changes in market conditions or asset values, we anticipate this will be used in future deals.
Exhibit 2 Significant purchasing power remains despite higher purchase price multiples being paid
Exhibit 3A Private equity dry powder across regions is high ...
Exhibit 3B ... helping to boost the unrealized value in private equity
Opportunities for investors in private equity exist both inside and outside the United States. Over the past three years, about one-third of the assets raised in the private sector have been earmarked for investing outside the U.S. This is likely to generate strong returns in PE; the basic beta return outlook for emerging markets and Europe now and in the longer-term is expected to be higher than for those of U.S. large- and mid-cap stocks.
Private equity opportunities in China and India look particularly attractive given that these large economies are in transition. China has an official five-year policy of converting from an export- oriented economy to a domestic one, creating a very large opportunity for financial sponsors. The International Monetary Fund recently upgraded its growth estimates for India even as significant reform is under way in the country—highlighting more opportunities, particularly around the middle class and the related products and services that its members consume.
In public equity markets, dispersion and volatility levels also have been rising, which, in turn, is creating a stronger case for active management. For example, with regard to expected volatility, the risk profile of passive investments will be set by the market, whereas active managers can proactively manage risk. In particular, in emerging markets, active managers with a local presence have strategic research advantages in looking across the breadth of equity opportunities to find growth potential within specific regions. In U.S. markets, as endowments and foundations are readily reevaluating their manager selection, active equity managers must delineate across a much smaller opportunity set along sectors in order to deliver target returns. Therefore, diversifying across styles or market caps can help add alpha or mitigate volatility in the equity allocation.
Real assets provide another attractive opportunity for endowments and foundations. Specifically, value-added or mid-risk1 real estate remains a bright spot. EXHIBIT 4 shows both that the commercial real estate supply remains far below demand and that non-residential supply has recently started to pick up. Employment growth is the primary driver for commercial real estate demand. In particular, demand is improving across the population segments that are prime users of high-grade office space.
Exhibit 4 Commercial real estate supply and demand are favorable for investors
Infrastructure investing represents another unique opportunity given the fact that many countries need to build or upgrade their physical systems (EXHIBIT 5). In Europe, which has almost twice as much dry powder to spend on infrastructure as the U.S., there is very strong demand for assets that can provide cash flow and consistent returns. While the high demand for infrastructure assets will soon bid down rates of return, today's available returns are relatively attractive at 9% to 10% for core assets in the U.S. and 8% to 9% for core assets in Europe.
Exhibit 5 Greater need for infrastructure spending indicates an area of opportunity
Exhibit 6 Middle-market lending is a fraction of what it was in 2005
The story in fixed income is, for now, a familiar one. Sovereign bond yields are likely to be negative in the short term. In our view, it will take another three years for fixed income yields to normalize in the U.S. and potentially another four to five years in Europe.
Despite this, there are some potential investment opportunities among benchmark agnostic and absolute-return managers. Absolute-return strategies generally seek to produce returns in any market and have wide tactical license to invest across government bonds, sovereigns, credit and floating-rate securities, among others. Such managers have recently outperformed more-benchmark-oriented managers by a percentage point or more in returns. For endowments and foundations, which generally have a 10% or lower allocation to fixed income and face annual distributions, this investment style provides a liquid, unconstrained approach to fixed income investing.
Opportunities in private credit are selectively available, as regulatory changes have forced many traditional lenders, particularly banks, to pull back on their higher-risk lending businesses. As EXHIBIT 6 illustrates, loans to middle-market companies are a fraction of what they were in 2005, creating opportunities for private investors to fill this funding gap on attractive terms.
Meanwhile, as the credit cycle has matured, there are new opportunities in private junior debt, which could generate returns in the low- to mid-teens and coupons that are 5% or more over the high-yield coupon rates. Junior debt, second lien and mezzanine debt—with about six- to seven-year terms with some type of call provision—may produce double-digit returns, with coupons in the 11% to 13% range. Including underwriting, fees and equity participation, we expect to see returns in the low to mid-teens in private junior unrated debt over the next several years or so.
In a market environment that is likely to be characterized by lower absolute beta returns, endowments and foundations are reassessing their asset allocation. Investment opportunities that can provide diversification, flexibility and premiums above publicly traded options—such as private equity, real estate, absolute-return fixed income and private credit—are likely to represent attractive options for not-for-profit organizations that can invest in less liquid, long-term investments.