ECONOMICS AND FINANCE

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• ECONOMICS AND FINANCE
• FOR ENGINEERS
• February 6, 2009
• Presented by
• William H. McLean, V.P. CIO
• Northwestern University

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Agenda

• Understanding the Endowment
• Asset Allocation
• Active Strategies
• Hedge Funds
• Private Investments

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Management Structure
Responsibility
Investment Committee

• Strategic Direction of Portfolio
• Review Asset Allocation
• Investment Policy
• Oversight of manager hiring/firing

Investment Office W. McLean, VP CIO

• Strategic and tactical issues for the portfolio
• Due Diligence process/manager selection
• Portfolio monitoring

Public
AR
PI
Oper.
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Long-Term Endowment Fund Spending Rule
Market Element 30 weight (Average market value for last 12 months times long-term target spending or 4.35) Spending Element 70 weight (Actual CPI 1.51)
Total (Millions) Per Unit Change Year-end Market Value
1996 55.2 3.62 3.1 3.59
1997 60.4 3.73 3.0 3.08
1998 70.3 4.17 11.8 3.53
1999 73.2 4.27 2.4 3.01
2000 95.5 5.30 24.1 2.92
2001 117.2 6.22 17.4 3.93
2002 130.2 6.56 5.5 4.67
2003 150.7 6.90 5.2 4.77
2004 160.4 6.87 - 0.4 4.37
2005 161.4 6.75 - 1.7 3.75
2006 176.2 6.81 0.9 3.39
2007 197.5 7.22 6.0 3.10
2008 233.5 7.80 8.0 3.36
2009 269.8 e 8.54 9.5 4.57 e
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Investment Objective

• Preserve purchasing power of Investments and
  provide a growing stream of Income for the
  Universitys programs.
• or
• Annual Total Return Spending Inflation

gt
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Investment Objective Annual Total Return
Spending Inflation
gt
As of December 31, 2008
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Endowment Growth (Through August 31, 2008)
Spending -1,850
Appreciation 4,821
Ending Endowment Value August, 2008 6,942
Net Additions 3,015
Beginning Endowment Value (1992) 956
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Endowment Assets
( in billions)
Source Cambridge Associates
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Agenda

• Understanding the Endowment
• Asset Allocation
• Active Strategies
• Hedge Funds
• Private Investments

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Long-Term Asset Allocation Process

• Establish risk and return expectations
• Establish constraints
• Propose target portfolio and ranges
• Compare target to peers
• Approval of new target and ranges
• Review of new asset class benchmarks

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Conventional Asset Return/Risk Perspective
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The Holy Grail of Investing15 or more Good,
Uncorrelated Return Streams
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Asset allocation using purely quantitativemean-va
riance framework
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Asset Allocation () Trends
June 30, 1988 June 30, 2008
27.3 Marketable Alt.
22.3 Non-Marketable Alt.
19.5 Global ex U.S. Equity
13.5 U.S. Equity
9.4 Total Bonds
7.8 Equity Real Estate
0.2 Cash
Source Cambridge Associates
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Asset Allocation gets more difficult when dealing
with multiple alternative asset classes

• Private Equity (Buyouts and Venture Capital)
• Illiquid assets not marked-to-market
• Long term (7 years) investment horizon different
  than that of publicly traded securities
• Separate asset class, but with beta to market
• Volatility does not capture true risk
• Hedge Funds
• Artificially created asset class collection of
  investment strategies that cover the breadth of
  asset classes
• Distribution of returns NOT normally distributed

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NU Asset Allocation
Preliminary As of December 31, 2008
  Actual Target   Low Range High Range
US Equity 10.5 14   11 17
International Equity 12.5 16   13 19
Fixed Income 10.4 10   7 13
High Yield Credit 7.9 5 2 8
Absolute Return 15.9 18   14 22
Private Investments 24.9 20   16 24
Real Assets 18.7 17   13 21
Cash -0.7 0  
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Total Endowment Performance
Preliminary as of December 31, 2008
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NU vs. Cambridge Associates Colleges and
Universities
(September 30, 2008)
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University Peer Returns (As of June 30, 2008)
3 Year
5 Year
1 Year
Source Cambridge Associates
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Agenda

• Understanding the Endowment
• Asset Allocation
• Active Strategies
• Hedge Funds
• Private Investments

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(No Transcript)
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Beta is pretty simple. What about alpha?

• Right now, alpha comes from 3 places

• 1) Traditional sources Active Managers
• Alpha is integrated into the product, but is
  easily identifiable

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Agenda

• Understanding the Endowment
• Asset Allocation
• Active Strategies
• Hedge Funds
• Private Investments

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(No Transcript)
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Allocation to Alternatives
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Hedge Funds are characterized by non-normal
distributions of returns
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Five Broad Hedge Fund Categories Encapsulate Many
Distinct Strategies
LONG-SHORT EQUITY
1
3
RELATIVE VALUE STRATEGIES
2
4
LONG-SHORT CAP STRUCTURE
GLOBAL VALUE
5
MULTI-STRATEGY
INSTRUMENT
EQUITY
CAPITAL STRUCTURE / CREDIT
INTEREST RATES
COMMODITY
MULTIPLE
L-S (Jones Model) L-S (Mkt Neutral) L-S (Short
Bias)
Deep Value / Catalyst Cap Str Arb /
Distress Distressed Active
Interest Rate Value
Commod. Value
Macro
VALUE
Merger Arb Stat Arb / Prs Trading Equity Deriv.
Arb
Convertible Arb
Fixed Income Arb Mortgage Arb
Commodity Arb
Multi-Strategy
ARB
STYLE
Note Multi-Strategy managers implement
subset of all other strategies across the broad
categories (indicated by different colors), and
allocate risk to the strategies in a proprietary
manner.
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Hedge Fund Risk Management

• Understand the strategies
• Understand the correlation among strategies
• Understand opportunity set of each strategy
• Set allocation to strategies appropriately
• Find the best managers to execute strategies,
  with strong emphasis on trust and integrity

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Non Market Risks Associated with Hedge Funds
Large Variation Across Strategy

• Limited History of Operations
• Leverage
• Tail Risk Correlation Convergence
• Liquidity Concentration of Portfolio
• Style Drift
• Short Volatility
• Organization Back Office
• Fraud

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Agenda

• Understanding the Endowment
• Asset Allocation
• Active Strategies
• Hedge Funds
• Private Investments

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Buyouts Fundraising
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Venture Capital Fundraising
Source NVCA
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Venture-backed Exits
MA
IPO
Source Venture Economics NVCA
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Trends in Private Investments

• FASB 157
• Denominator Effect/Quest for Liquidity
• Secondary Transactions (LP and GP)
• Tough Fundraising Market
• Emerging Markets
• Longer Holding Period
• Shake-out in the system? Is the model broken?
• Increased of Investors in the Market
• Difficult to Access Top Tier Managers

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Private Investments Emergence of Mega Funds
Prior to 2004 2004 -2006
Funds gt 3.5bn 9 19
Funds gt 6.0bn 3 10
Funds gt 10bn 0 5
Includes funds scheduled to close/closed in
2006. Apollo, KKR, Bain, TPG, Blackstone. Source
Willis Stein Partners
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Nine of the ten largest deals occurred in
2005/2006
Highlighted deals represent Northwesterns
Exposure
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GP Management Company Sales

• Retention tool or cashing out?

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NU Alternatives Portfolio

• Investment program began in 1993
• Four managers oversee the program
• Currently represents 50 of the total endowment
• Includes hedge funds, buyout, venture capital
  partnerships, real estate, energy and a
  Co-investment program
• Mature portfolio but with opportunities to
  diversify
• Long term investor mindset

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NU Private Investments Portfolio

• Currently represents 20 of the total endowment
• Includes buyout, venture capital partnerships,
  Co-investment program

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The Investment Process

• Review Private Placement Memorandum and have
  initial meeting with GP
• Follow-up meetings
• Due diligence
• Investment Memorandum
• Negotiation of terms
• Receive Approval from Investment Committee/
  Closing
• Monitor performance, build relationship

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Due Diligence

1. Strategy
2. Management Team
3. Performance
4. Terms

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Strategy

• Consistency across funds
• Differentiated in the marketplace
• Fund size supports strategy
• Deal sourcing ability
• Deal structuring
• Purchase price multiple, leverage, management
  ownership
• Ability to exit in various markets

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Management Team

• Background
• Cohesion
• Tenure of the team? Stable partnership?
• Carried Interest allocation within team
• Deal and board capacity
• Motivation of team
• Reference checks

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Performance

• Realized deals
• Source of realization disposal, dividend, recap
• Dispersion of returns
• Unrealized deals
• Current valuation method 3rd party, EBITDA
  multiple at purchase vs. market, public shares
• Deal attribution by partners
• Source of value creation
• Gross IRR/Multiples v. Net IRR/Multiples

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Terms

• Management fee
• Carried interest
• GP commitment
• Key man provision
• Clawback (guarantee)
• No fault divorce clause
• Transaction fees, director fees offset

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• Questions