Why Have Private Equity Markets Struggled? Is Your OCIO Adapting to Private Equity Market Changes?

Our position as both an OCIO search consulting firm and an alternative investments due diligence provider at Manager Analysis offers an interesting vantage point: while we see how OCIOs allocate into alternative investments, we also see a decent sampling of the quality of alternative investment opportunities that the OCIOs are assessing. We observe that, while compelling opportunities continue to present themselves, average return prospects have also greatly diminished, evidenced by greatly reduced IRRs and very slow distribution rates now persisting for the last three years. 

Nonetheless, many OCIOs hope for a recovery in PE performance and liquidity.  They continue to advocate for building out PE portfolios, diversified by class year and strategy grouping.  We have not yet seen OCIOs accept a prospect for diminished privates returns.  Rather they observe that PE markets have recovered very quickly from past down-cycles in subsequent years, so they believe it is critical to sustain the pace of allocations during times of weak performance.

Have return prospects actually changed for private markets?  Should OCIO behavior be a concern for OCIO clients?  What would we want OCIOs to do in the current PE market?

After Adjusting For Sector Selection, Has Private Equity Really Outperformed?

The existence of widely dispersed investment returns among private equity and venture managers makes these markets a compelling choice for any allocator that believes they have skill in manager selection.  We meet few allocators who don’t believe they have such a skill, but nonetheless even without exceptional manager selection skills, hitting the average was still a success over the long term.  Allocators for private equity have typically sought excess returns of 3% to 5% over comparable public market returns, and private equity’s long-term returns have, until at least 2022, supported that premise. 

But is that outperformance a reflection of private equity managers making skillful selections of enterprises for investments, or something else?  For instance, PE managers have had a strong bias toward information technology-related businesses over other sectors.  The Russell Technology Index earned an average of 19.7% over the last 10 years to May 30, 2025; compared to 11.0% for the S&P 500 and 5.1% for the Russell 2000. When we consider that the typical private equity fund has a 36.6% allocation to information technology [IT], compared to 14.0% for the Russell 2000 [figures are from Cambridge Associates https://www.cambridgeassociates.com/insight/us-pe-vc-benchmark-commentary-first-half-2024/], the typical PE Fund should outperform public markets.  For example, using public market equivalents [PMEs], the higher return from the higher IT weighting creates an alpha versus the Russell 2000 of 5.8%. The IT sector weight in the S&P 500 is about 27.5%; the extra tech weight there adds only about 0.9% alpha versus this large and megacap index over those 10 years. 

Looking at performance through June 30, 2024[1] we see that Cambridge’s PE index outperformed the Russell 2000 by 8% and the S&P 500 by 2% over 10 years through June 30, 2024.[2]  In fact, our sector-adjusted PME estimates for PE explain much of the actual performance: about half of the outperformance versus the poorly-performing Russell 2000, and 1 percentage point of the 2% outperformance versus the S&P 500. 


[1] Performance may appear stale but this data was released in March 2025 and does not overly rely on interim estimates.

[2] Our PME adjusted alphas for the 10 years through June 30, 2024 are close to those through May 30, 2025: 3.65% versus the Russell 2000 and 0.87% versus the S&P 500.

Have Private Markets Fundamentally Changed?

From our diligence work, we observe that investing in Private Equity markets has become more difficult.  For private equity, we see the following challenges:

Middle Market Company Underperformance Also Impacts Private Equity Investing

PE performance has been set back because the earnings of America’s middle-market companies have vastly underperformed the experience of America’s publicly traded companies.  In a study prepared jointly between Marblegate Asset Management, a distressed private debt investor, and RapidRatings, a credit assessment firm, the authors found severe financial deterioration among middle-market companies with sales between $100 million and $750 million per year—prime hunting grounds for private equity managers.  Their 2024 update paper is “Dragged Out to Sea:  The Ongoing Stress and Distress in the U.S. Middle Market – an Update to 2023’s “Riptide: The New Era of Acute Financial and Operating Stress in the U.S. Middle Market”” [see FundFire article https://www.fundfire.com/c/4852394/660564/middle_market_train_wreck_marblegate_warns?referrer_module=sideBarHeadlines&module_order=0],  and they expect to release an update showing similar results shortly.  The authors incorporate full year 2023 financials from RapidRatings data for over 1200 private non-financial middle market companies and a cohort of public companies from the Russell 3000, to show the ongoing deterioration in the financial performance of the middle market companies as predicted in their original paper.  A few tables from their paper highlighting this deterioration are quite revealing:

The study shows a surprising amount of distress among middle market companies.  Net Profit After Taxes [NPAT] fell almost 80% from 2019 to 2022, and showed net losses in 2023.  EBITDA fell almost 40% over four years to 2023 while borrowing increased 45% and leverage 1.4x.  Servicing debt alone is very difficult, with interest coverage falling 73%.  Marblegate concludes that “This dramatic decline for middle-market companies likely reflects a combination of higher input costs, increased debt service expense and limited pricing power.”

Unsurprisingly, the struggles of middle market companies seem to be reflected in public market equivalents.  It is helpful to observe graphically the performance over the last 10 years, with the S&P 500 [middle line] having vastly outperformed the smallcap Russell 2000 [bottom line], and IT stocks [top line] achieving the highest returns:

Given the more recent challenges of the middle market, should we care more about shorter-term performance than longer-term performance as an indication of PE market’s return profile?  Looking again at Cambridge’s PE performance table, PE has vastly underperformed the S&P 500 from June 2021 to June 2024 [6.9% vs 10.9%], while outperforming the abysmal performance of smallcaps [6.9% vs -1.4%].   So from this viewpoint, PE does appear to be adding value versus smallcaps, likely reflecting a mix of skill in avoiding the more problematic middle market companies, selecting and managing sound businesses, and a bias toward investing in IT businesses.

The net result is that PE returns reflect the successes and struggles of the broader middle market, with a bias toward IT businesses.  PE might be characterized as a competing allocation for small and microcap stocks, with similar return and diversification benefits.  The approach of using PE to build an asset allocation model with a small/microcap framework might be more suitable than assuming PE returns of “market plus 3%” with unbelievably low volatility.

This public-markets equivalent viewpoint on PE modeling mirrors my previous look at venture capital markets, albeit from the other end of the market capitalization spectrum.  See “Venture Capital Versus the Magnificent Seven” which we published in January 2024.  In this paper we assert that the large R&D budgets of megacap firms, which are collectively larger than capital deployed annually in venture capital, means that investors in these firms are already meaningfully allocated to the more successful part of venture investment activities.  Conversely, the Cambridge venture capital return data does not show, on average, compelling venture performance versus public market equivalents.  Nonethless, truly exceptional investors in venture capital can still experience truly exceptional results. 

Ramifications of Lower PE Returns on PE Investment Strategies

At Manager Analysis Services we believe that investors’ frustrations with their recent PE returns reflect the dynamics of companies in America’s corporate middle market. We are seeing PE managers respond to the environment by trying to protect their businesses’ earnings potential. With PE funds’ underlying portfolio companies performing far below expectations, we believe that PE managers are holding investments in these companies longer, hoping for a recovery so they can meet their hurdle rates and potentially earn some carry.

The consequence of this “hold for longer” dynamic is that exit rates for PE funds have slowed dramatically over the last three years, leaving markets to find alternative sources of liquidity.  The rise of secondary funds reflects market demand for liquidity.  PE managers themselves are also embracing new investment structures that allow their funds to hold investments for longer, and in some cases, reset their carry terms through continuation vehicles and other structures.  Purchases of captive investors like insurance companies, creation of interval funds, and efforts to access retail sales channels represent a combination of aggressive distribution strategies and a repositioning for future illiquidity. 

These strategies indicate a likelihood that investors must be extra vigilant that the PE managers for their future investments have both the will and the capability to execute a PE strategy that is consistent with the investors’ expectations for timing of return of capital.  They also indicate a stress upon the reliability of the historical experience, that buyout and growth PE funds would typically be able to return capital on average every 4 to 7 years.  We believe that investors in PE today should be prepared for the prospect of much longer effective commitment horizons for new PE investments.

Is Your OCIO Smarter than the Ivy League Endowments?

While the endowment and foundation world has historically looked to the Ivy League endowments for ideas and inspiration, their more recent performance has reflected the challenges we discuss in this Briefing.  Illiquidity is a huge problem.  The following chart shows the extent to which Ivy League endowments have overextended their commitments to private markets, with unfunded commitments consuming on average 45.6% of their liquid assets, according to a study by Markov Processes:

https://www.markovprocesses.com/blog/a-private-equity-liquidity-squeeze

The combination of any future recession alongside material cuts in government grants for these schools could create major challenges for these institutions.

https://www.markovprocesses.com/blog/elite-u-s-endowments-government-funding-and-liquidity-pressure

While these very respected endowments remain committed to keeping large PE allocations, some are clearly responding to being overextended.  Both Harvard and Yale have announced curtailments or sales for portions of their private holdings.  They will likely be disappointed with the secondary market values for their holdings.

What We Are Thinking About OCIO Allocations to PE

We do believe that PE markets have achieved maturity and that on average PE managers will struggle to outperform public market equivalents.  We question the historic assumption that PE markets will rebound simply following the historic pattern of rebounds.  Instead, we think PE markets will reflect the subsectors into which the PE funds have allocated, and the fate of America’s middle market.  If the middle market recovers, so will PE; if they continue to struggle, so will PE.

We believe that past use of public market equivalents made faulty comparisons to large cap markets, and that the small and microcap markets are more suitable benchmarks.  We question how PE is classified as a separate class within equities, and we think that OCIOs should pay closer attention to the underlying sector allocations of their PE fund holdings.  OCIOs should ensure that the sum of their PE funds’ sector exposures are in line with the OCIO’s overall desired market sector exposure.

Despite these observations, we do believe that PE markets continue to offer very attractive investment opportunities for sophisticated investors.  The very high dispersion in returns across PE managers and their funds offers evidence that having exceptional manager-picking skills in PE markets is imperative.  Moreover, we caution embracing the skeptic’s view, that PE markets just don’t add value after adjusting for sectors.  Rather, the PE managers’ embrace of entrepreneurialism is exactly what caused them to concentrate in the best-performing investment sector, information technology, over the last ten years, creating substantial value for investors.

OCIOs should focus their PE investment efforts on areas where they have the strongest quality-sourcing capabilities for private investment opportunities.  If the OCIOs believe, as do we, that PE funds tend to track the performance of the middle market and its underlying business sectors, then it is somewhat less important to have a truly diversified PE portfolio, because public market equivalents are available.   Instead, OCIOs can maintain higher liquidity for clients while targeting scarce resources on sourcing the best managers in sectors they find compelling for their clients.  What we have seen working best is a sort of barbell by PE manager type: investing in already-established relationships with a small set of capacity-constrained, highly performing premiere PE managers; sourcing boutiques and sector pros who avoid “auction markets” and who can find their own management talent to run their portfolio companies; and avoiding the “asset gatherers” who will struggle to add value compared to relevant public market equivalents. 

Information about us is on our website www.manageranalysis.com, and we would welcome a conversation with you about this Briefing. 

Sincerely,

Chris Cutler, CFA

President

Manager Analysis Services, LLC

917-287-9551

Can OCIO Evaluations Be “Free?”  Benefits of Reviewing Your OCIO Over a Full Market Cycle 

In addition to conducting OCIO searches, we also evaluate OCIOs for clients that want a “wellness check” on their OCIO relationships.  These clients find our OCIO evaluations informative and helpful, and thankfully, for the most part clients find that they remain satisfied overall with their current OCIO provider. One area that clients find particularly enlightening is having their OCIO advisory fees “marked to market,” particularly where reviews have not been conducted for more than four years.  Potential fee savings are often a multiple of the cost of an OCIO review. This can essentially make the evaluation “free” and result in an annual saving to the client. Review of an OCIO over a Full Market Cycle aligns with the industry practice of reviewing any investment manager performance over a market cycle.

Here are other common themes found in our OCIO reviews:

  • Conflict of interest from OCIO Self-Evaluation: Many OCIO clients excessively rely on their own OCIOs to self-evaluate their performance. We see many cases of OCIOs reporting their performance in the best light, and not comparing themselves to appropriate peer groups.  This practice occurs because evaluating OCIOs requires specific resources and expertise that often is hard for OCIO clients to access internally. Our evaluation service closes this gap.
  • OCIO Performance Evaluation:  Particularly over the last three years, some OCIOs have experienced substantial negative alpha on their liquid, actively managed equity strategies.   Often more than offsetting that negative alpha has been strong performance in private equity investments.  We can help you ascertain whether the recent record of negative alpha in equity strategies is a warning sign, or is a reflection of temporary market conditions.  We can also help you evaluate the quality and scope of your OCIO’s private investments program.
  • OCIO Alternative Investments Success Evaluation: Almost all OCIOs have embraced private investment strategies for a portion of their clients’ portfolios.  However, some OCIOs have moved very quickly into private investment strategies, and some may not have built out experienced diligence teams nor developed robust investment premises behind their private investment programs.  This development could be a material risk to you, because the long-term nature of private investments means that you are “stuck” with any errors made for a 5 to 10 year horizon.  We are experts at evaluating private investment strategies, so we can help you calibrate your OCIO’s strengths in private investment strategies.

We would welcome a conversation to show how we can help your specific situation during which we would be pleased to share a sample OCIO Evaluation Report with you.

Since 2003, Manager Analysis has provided investment research and support for clients.  All 3 principals each have 30+ years investment expertise, including having led 3 different private foundations and having served on 11 different Boards. 

We can be reached at 917-287-9551 and at cutler@manageranalysis.com.

Terrible OCIO Performance Merits Your Attention

Many fiduciaries have been challenged by their OCIO’s performance this year, and question whether their OCIO’s performance is acceptable in light of terrible market performance [S&P 500 down 14% plus and bonds down 10% to 15%]. Returns are actually worse after considering 8% inflation, and many fiduciaries are finding that the actual buying-power is down over 20% in
real terms.

What steps should you take that properly support your decision to retain your OCIO, or to explore whether you should search for a better-performing OCIO relationship? We suggest that a first step is to consider whether your OCIO is performing satisfactorily, relative to market conditions, to help inform your governance efforts:

Market returns have been exceptionally poor 2022 YTD. This year is only the third year since 1900 when both equities and bonds indices were both down. (2015 and 2018 were the other two years.) Indeed all 11 S&P sectors suffered with the notable exception of energy (+34.5%). Certain alternative funds provided effective diversification. Those OCIO managers that were sufficiently nimble to layer in protective equity puts, pivot to energy, avoid long duration fixed income, and focus on specialized hedge strategies were best able to reduce overall market losses. It is these types of OCIO managers who are the standouts.

Conversely, we have seen OCIOs underperform from several causes. OCIOs that pursued 60/40 allocations that did not dodge rising interest rates’ impact on their bond portfolios received a double hit. OCIOs that focus on “alpha creators” for their long only equity managers [an allocation approach we meet with great skepticism] also were hit hard by the fact that those OCIOs really didn’t diversify by style, and many of their managers are growth-and-tech bias at the epicenter of underperformance in year’s value-oriented equity market. OCIOs with a strong “geographic diversification” [i.e. underweight in the US markets] were hit by falling European currencies and weak European equity markets. Finally OCIOs that tend to use equity-oriented hedge funds missed the benefits of having the full suite of hedge fund strategies.

Whether you wish to continue your OCIO relationship or are considering a search potentially to replace your OCIO, we recommend that, as fiduciaries, you evidence that you have reviewed your relationship if you have had losses near or over 15% this year. We specialize in evaluating OCIO portfolio performance and can assist you in providing an objective third party analysis. Manager Analysis Services has nearly 20 years’ experience in this field. We offer your fiduciaries a complimentary discussion of your OCIO’s performance, and whether you should take further steps.

We welcome your call at 917-287-9551.

Borrowing Opportunities for an Endowment or Foundation

Borrowing can be used for offensive as well as defensive purposes. Typically, it takes the form of a Letter of Credit or borrowing under a Securities Lending Agreement.

Research has shown that Endowments will often use lines of credit offensively to fund private equity capital calls. It enables better cash management and investment timing. Smaller Foundations tend to use lines of credit for that same purpose. Foundations also use Securities Lending defensively to avoid selling “underwater” equity positions to fund current grantmaking. This can make sense if the Foundation views itself as a perpetual investor and the equity sell-off is considered a temporary or short-lived phenomenon. (One should ensure that the Foundation’s governing documents either enable or do not preclude borrowing.)

Lines of Credit – Typically arranged with a bank and often is uncollateralized.

Securities Lending – Collateralized borrowing is an active part of the financial markets and many market players engage in this type of lending to boost returns.

We envision Securities Lending as a defensive means for Foundations or Endowments to avoid selling “underwater” equity positions, rather than “locking in” a loss. Securities Lending agreements are highly standardized and sample templates are available on the Internet. (You should of course use your own legal counsel) but the internet documents do provide the reader with a sense of the wide use and standardization that exists.

Goal – If the entity has a perpetual time horizon and believes that the equity markets typically rebound within a 2- or 3-year future time horizon, borrowing may make long term sense.

Collateral – Typically one would pledge securities that would be placed with a custodian. (Securities may need to be “aged”, i.e. fully paid for and have been held for a minimum time period, e.g. 1 month, prior to pledging.) The advance rates would be based on the specific assets pledged. Typically, the rate would be Libor + a spread.

Want to learn more? Please contact Chris Cutler or Tom Donahoe

The 7 Steps to Selecting an OCIO

We have led OCIO searches and selected providers as well as analyzed many additional completed OCIO searches. We’ve distilled the process down to 7 key steps. They are as follows:

CATALYST – There are typically specific concerns that trigger a search: performance, portfolio concentration, liquidity, poor service, and/or fees. Survey participants often tick the box as “fees.” While often true, we believe that “fees” may often be a stalking horse that provides cover for other motivating rationales.

AWARENESS – The Investment Committee or Board needs to educate themselves as to what’s available in the market. This takes time and direct interaction between providers and Board/IC. Internal staff is often understaffed and is not able to distill the information on a timely basis. (Surveys show internal investment staff to be 0.5 FTE or less.) Moreover, staff members may wear multiple hats and investing oversight may be hampered by manual processes.

GOAL(S) – Investment Committee members should agree on a clear articulation of the organization’s goals. If this is left vague or allows late-entrants into the bidding process, it will reduce the efficiency and transparency of decision making.

IDENTIFYING ELIGIBLE OCIO PROVIDERS – This requires someone with industry expertise, time in markets, and understanding of client’s needs and goals.

REQUEST FOR INFO – This should precede a formal RFP. It is a list of 5 to 7 key questions that are submitted to a larger, potential universe of OCIO providers. This enables you to surface issues (conflicts) early, review each submission on a conference call with the provider (and get a feel for working with that team.) You then go out with a formal RFP to a distilled subset of your RFI respondents.

INTERVIEW – This is essentially a semi-finalist stage. Then, there should be an on-site visit at the provider’s place of business once you are down to the finalists.

DECISION – Always have a first choice and a back-up, in case the first choice does not result in a final agreement. Entire search process is typically 3-4 months.

Want to learn more? Please contact Chris Cutler or Tom Donahoe.

Governance – Using Progressive Term Limits and the Emeritus Issue

Trustees are a great asset, provided you select and support them diligently.

The governance structure of non-profits tends to be the mirror opposite of for-profit organizations. It is a simple reality that those long-term board directors in non-profit institutions usually shape the policies and direction of their organizations. Having an effective governance strategy for selecting and rotating board governors is a great way to ensure that the non-profit institution has the right set of committed and unconflicted talent serving as directors.

Typical TenorsFor-profit CompaniesNon-profit orgs
(Institutionalized)
Non-profit (founding
family-majority)
CEO tenure6 – 10 years10 – 20 years+20 years
Board tenure+20 years9 years (maximum)No real limit
N.B. – A non-profit Board is not considered “institutionalized” if the founders retain a Board majority.

Progressive term limits protect the institution:

Board member terms are best staggered, (similar to the US Senate, only 1/3rd of Trustees seats should become open each year.) This ensures stability and thoughtful transitions. Having three 3-year terms seems quite tidy but can make for an untidy mess. You expose yourself to “social loafing”, disruptive actions, and perhaps embrace too much risk with a new, untried Trustee.

As an alternative, one could implement progressive terms: initially 1Y term, then 2Y, and finally a 3Y term (you’ll know after 3 years if a director is good.) The rationale is that you could identify a new Trustee’s poor participation or lack of commitment early on, and this structure offers you a convenient (non-confrontational) way to limit damage to the institution. Also, try to avoid the romance of focusing only on the well-credentialed. You need to understand why a person is joining and if the new person also serves on another Board with one of your current Board members. This may result in a conflict.

A typical bylaw provision allows the “firing” of a Trustee at any time. In real life, most Boards simply plod ahead and refuse to face the friction of a contested exit that often requires near-unanimous agreement on ejecting a current director. A real-life anecdote is instructive. A Trustee missed 5 of 7 meetings and was considered “effectively” resigned. The Board woke up one day to a scathing press release that the Board member was “resigning in protest” about a sensitive issue.

Emeritus Status:

In a word, don’t! It’s better to have an annual dinner with current and past Trustees. Emeritus is an active designation and holders believe it confers power/access/voice in current decision-making. Emeritus may demand to see current minutes, etc. It is better to honor completed, past service. Moreover, ex-Trustees often simply want access to the library or email address. This can simply be approved by the Board and arranged by staff. Moreover, emeritus has often been given to large donors and this tends to annoy past Board members who served well but simply don’t have a thick wallet.

Want to learn more? Please contact Chris Cutler, Tom Donahoe, or Safia Mehta at 917-287-9551.

Ten Tips to Turbo-Charge Your Trustees to Max Performance

You’ll find below ten low cost, handy steps that can be implemented at your Foundation without spending Foundation resources.

  1. AN INDEPENDENT GUIDE TO TRUSTEE DUTIES – For onboarding new Trustees or ensuring that current Trustees fully understand or are refreshed in their duties; the NY Attorney General’s office publishes RIGHT FROM THE START and also INTERNAL CONTROLS AND FINANCIAL ACCOUNTABILITY. What better way than having a neutral, authoritative voice review the Duties of Care, Loyalty and Obedience in a clearly written dispassionate prose?
  2. START WITH THE TOUGH TOPICS – At Board or Committee Meetings, address the toughest topics first, do not let them hide deep in the agenda. Everyone is freshest and most alert at the beginning of the meeting. The priority topics will also ensure that Trustees join the meeting at the start. Ensure that there is a published time limit for each agenda topic.
  3. PROPOSED MOTIONS SHOULD BE DRAFTED IN ADVANCE – Draft proposed motions BEFORE the Trustee meeting. This ensures a thorough drafting, unrushed by time pressures. It also provides a document to speak to and use as a gauge. The meeting also does not devolve into a word-smithing exercise that eats up valuable Trustee time. If multiple motions are needed or pro- and con- motions, those also need to be shared with the Trustees before the meeting. (Ideally via a link to Cloud storage.)
  4. FUTURE TOPICS – Provide a list of planned topics on a rolling 3 quarters in advance so that Trustees know when major recurring topics will be addressed. They can also anticipate what projects might be helpful to align with the timing of future meetings.
  5. TIMELY SCHEDULING OF COMMITTEE MEETINGS – Require that periodic Committee meetings be scheduled at least ten days to 3 weeks before the actual Board meeting. This ensures that information distilled will be current and avoids a rush analysis in order to place items in the “Board Book” in preparation for an actual Board meeting.
  6. RECORD THE BOARD MEETINGS – It helps resolve disputes about what was said and ensures the accuracy and timeliness of the Board minutes, even if they are written weeks after the actual Board meeting. (Recordings can be deleted after one year or on a pre-agreed basis.)
  7. FOUNDATION EMAILS – Require all corporate information to be communicated on Foundation emails, which means that all Trustees are assigned foundation-domain email accounts. As a potential compromise, Trustees may continue to use their personal accounts, but ALL emails need to be cc’d to their foundation email accounts. (The latter is not best practice but may be a viable work around if not abused.)
  8. SOCIAL CAPITAL – All groups work best together if there is social capital built up. You should not solely rely on telephone meetings. There should be periodic meetings in person, even if only on an annual basis. The annual meeting or at least one meeting per year should be held at the site of the Foundation’s location or activities.
  9. INSURANCE – You absolutely need to review ALL your insurance coverage on an annual basis and in-depth. Risks and coverages change, and insurance gaps provide a potential for a major loss to a Foundation if not properly addressed. Trustees may want to focus on D & O coverage and be conversant with any “indemnity” coverages that the Foundation has agreed to provide, typically in its bylaws.
  10. CONFLICTS OF INTEREST POLICY– There are few topics other than conflicts that can cause as much damage to a Foundation, either reputationally or financially. With the Internet, scandal spreads quickly AND permanently. Your policy must allow for Audit Committee review, especially in a case of first impression. Avoid any appearance of conflict. An outside law/audit firm review could help.

Want to learn more?

Please contact Chris Cutler, Tom Donahoe or Safia Mehta at 917 287 9551.

The 3Y or 5Y OCIO Check-up (Fees Checked Every Year!)

Here’s why… Your needs change and the composition of most Investment Committees typically change over a 5-year period as well. The coverage and (more critically) the investment decision makers at your OCIO can change as well, all too regularly. (Fees should be reviewed and evaluated every year even without an RFP, simply because of a Fiduciary’s Duty of Care.)

If investment performance has been good (acceptable) and interactions with your coverage have been timely and beneficial, an RFI would seem entirely appropriate. You have a good relationship already and you simply want to validate that you are achieving the best results that your organization can achieve.

The RFI is composed of your own brief set of questions. The answers you obtain should inform you as to your next steps. You essentially validate whether the OCIO is helping you fulfill your mission or not. If you determine that the current OCIO arrangement is not optimal, then it may well be time to undertake a formal and comprehensive RFP process to replace the existing OCIO.

A Sample of 3 Key points to focus upon with a 5-year check-up:

  1. RETURNS – Your returns versus peers and versus the market benchmark(s). If there is underperformance, try to establish the root causes: asset allocation, re-balancing discipline, portfolio concentrations, overreliance on specific factors, etc. It is important to understand the “why” of what is not working properly for you.
  2. RISK PROFILE – Many providers continue to provide a crude (simplistic?) analysis of the portfolio’s risk profile. You deserve detailed graphs and tables (they should be presented in an intuitive fashion) since the analytical programs and tools are so readily available in the industry.
  3. COMPARISON TO PEERS – Your OCIO should provide you with insight as what is changing and what seems beneficial amongst your peers in the market space. You may learn of innovative approaches as to all aspects of investing, analysis, reporting, training staff, etc. There are often steps that can be taken to achieve greater efficiency and transparency that are simply operational and not proprietary in nature. These shared insights can improve your own efforts and organization. The OCIO can share these types of insights.

Want to learn more? Please contact Chris Cutler, Tom Donahoe or Safia Mehta at 917 287 9551.

Exposure to Diligence Performed by Your Institutional Investment Consultants

Allianz GI Structured Alpha Fiasco: Could It Happen in Your Pension Plan?

You have surely read how large pension plans invested in Allianz’s Structure Alpha strategies, each losing 5% to 50% of their assets, in March 2020. How could such catastrophic losses happen when these pension plans were all supported by board directors, investment staff, and large investment consultants? Is that not the model used by most large pension plans, including your own?

We think every pension plan should review the entirety of their investment governance process. The strong similarities in your governance process to the loss-ridden pensions, alongside increasing degradation in the quality of work at some large investment consultants, suggests that your pension could lapse into similar mistakes quite easily.

What Happened with the Allianz Strategy and Why Does It Matter?

First, let us review what actually happened with the Allianz Structured Alpha losses. Prominent investment consulting firms recommended it, pension staffs endorsed it, and pension boards approved it. The program superficially looked quite appealing as it did produce higher returns for years. The important caveats that its investors missed are that it could produce a -100% return in a market crash, like the one in March 2020, and that the Funds charged clients exceptionally high fees for the services provided. Some pension boards placed 5% to 7% or more of their portfolios in this single high-risk strategy with a single manager, and then lost 75% to 97% of all their monies invested. Frankly the return-enhancement strategy—selling “lottery tickets” in the form of far out-of-the-money put and call options—is widely viewed as highly speculative among sell-side risk managers, who would actively resist their own bank and brokerage traders from ever pursuing such a strategy.

We are of the view that a strategy so highly speculative and that increased the adverse correlations so dramatically in extreme scenarios, does not belong as part of a pension plan portfolio. Certainly, not in the sizing that occurred across so many pension funds.

How did it get into the pension portfolios? Most board directors, through no fault of their own, never worked at an investment bank or on a trading floor, and thus board directors rely heavily on staff and investment consultants. Some of their staff should have the expertise to have recognized the strategy’s weakness in a market crash. Large investment consultants should certainly have understood that the strategy did not belong in most clients’ portfolios, yet they still recommended, approved, and endorsed these investments for their pension clients. The enormous losses of $6 Bn+ spread across a large number of institutional consultant-advised pension funds evidence that there are structural problems that are needlessly exposing pension funds to enormous risks.

Key Areas Where Pensions’ Existing Investment Protocols Become Unreliable

We find that pension plans face several key areas of vulnerability with their existing investment process:

Faulty Internal Processes – Internal due diligence processes often have rigorous and lengthy checklists that provide investors with a false sense of comfort. It would be easy to see the Allianz strategy score highly against a detailed yet naïve checklist, presenting as it did a very attractive multi-year performance track record and managed by a large, deep-pocketed asset manager. No checklist is a substitute for investment expertise. If staff, the investment committee, and the investment consultant think they understand the strategy, but do not, the checklist approach will amplify the collective sense of false confidence.

Excessive Reliance on Institutional Investment Consultants – Pension staff and board directors rely heavily on the large investment consultants to perform a thorough analysis of each manager and strategy. Pensions should also be paying attention to what is happening inside the large investment consultants. Many have become for-profit firms that are not necessarily focused on providing the best research, and some of their due diligence reports read more like cheerleading for managers than presenting a balanced assessment. We have seen senior due diligence staff report to accountants and deep cuts to manager research efforts following acquisition by for-profit firms. Some consulting firms also face myriad conflicts of interest that may not be adequately disclosed. These problems are exacerbated by the extremely low fees paid to pension consultants. We have even seen employee-owned investment consulting firms themselves outsourcing their due diligence work. With the Allianz situation, we have seen some involvement by three different large consultants, so this type of failure is prevalent.

Pension’s Internal Investment Staff Lacking in Numbers, Training, or Experience – Earning a CFA or CAIA credential should ensure that the employee is qualified to understand and evaluate a simple strategy like Structured Alpha. Yet, one remembers the axiom about doctors: the procedure they are about to perform is the topic they got wrong on the medical boards! The same holds true for CFAs and CAIAs. An additional risk is that frequent employee turnover, common in the investment industry, or lack of professional development for staff, can disrupt the diligence and controls.

Even with an outstanding internal team, asking them to cover too many investments can lead to material oversights and omissions. Pension investors should carefully assess whether their processes include sufficient internal analytical resources to pursue the breadth of strategies in their portfolio. Needed workloads should be carefully quantified and compared to the workload asked of staff, to ensure a good alignment.

Limited Bandwidth of the Board Directors – Investment committees often contain members with varying degrees of investment expertise, or with substantial outside commitments. Often less vocal committee members feel may hesitate to challenge the more forceful voices, but they miss the opportunity to voice important insights. Nonetheless, the fiduciary duty remains with the full investment committee and ultimately with the board. Board directors could face liability issues if they fail to detect major omissions in the pension plan’s investment process. With the apparently diminishing reliability of the larger investment consultants, we believe board directors will face an increasing number of crises in their portfolios, along with the potential risk of personal liability.

Recommended Solution – Undertake an Investment Governance Review

The catastrophic losses in the Allianz funds occurred for investors despite a perceived robust investment process. Pension fund fiduciaries are right to be concerned about other possible problematic holdings already in the portfolio that have escaped proper vetting. There is a solution already widely available to help ferret out these “ticking time bombs.” An Investment Governance Review [IGR] addresses the following critical areas:

Governance Review – A review of the entire processes by which your pension considers, reviews, monitors, and deploys capital, to ensure that your duties of care and loyalty are met. This review is a detailed, step-by-step examination of the governance structure and how the duties are discharged. This would help ensure that the Board fulfills its Duty of Care as fiduciaries. Such an assessment, an “Investment Governance Review,” should occur at least biennially, if not annually. including:

Complete Portfolio Review – The assessment would review all current holdings with an eye to identifying whether the investment holds material hidden risks, correlations, or weaknesses, and whether the investment is properly characterized in the pension’s holdings and risk reports.

Assess Your Diligence Processes – A thorough review of diligence and approval processes typically leads to improvements in diligence practices. While no investment process is perfect, identifying strengths and weaknesses can help pensions mitigate and manage risks so that the portfolio will perform in a manner consistent with expectations. Moreover, our review often leads to improved future performance of investment staff, who become more effective with improved investment processes, and better at prioritizing and communicating with board directors. Too often, in-house analyses are colored by employee compensation concerns, wanting to avoid challenging the party who recommended the investment, or unwillingness by employees to admit that they simply lack the ability internally to analyze certain types of structures or asset classes. Complacency can arise when an investment has been held for a multi-year period, its returns are within the expected range, or alternatively the Pension Fund holds other investments obtained from the same provider. In such circumstances, style drift and changing risk profiles can be easy to overlook. We identity misalignments and provide recommendations on how to reduce or eliminate those problematic vulnerabilities.

Robust Analysis of Problem Investments – The Board may well be concerned with a specific investment that they currently own and have a vague/strong feeling of discomfort. We can perform a specific one-off analysis to vet the strategy, structure, and risks of a specific investment. Too often, the board directors see the investment listings neatly lined up in a report and the completeness of the report is assumed since all investments are listed. We would point out that the quality of the data that populates a holdings report (or risk report) can vary dramatically by asset type and structure, liquidity, and other critical factors. Often there are short cuts, estimates or other expedients or manual adjustments made that are not captured or disclosed on the report. These artificial constraints or “plug factors” can be themselves concealing risks or vulnerabilities from the Board.

The Allianz Structured Alpha Funds evidenced a fundamental failure in basic due diligence. In fact, the strategy can be viewed as quite simple with few moving parts. Surely there was sufficient expertise within each Pension Fund to perform a sufficient analysis. The strategy was simply the sale of put options on equity and sale of volatility options and the Fund pocketed the option premiums which were described as income/returns. Several of the largest losses occurred where the plan sponsor did hire large investment consultants to track and report on risk but that proved in retrospect to have provided a false comfort. For less than $20K per investment, these plan sponsors could have easily hired an independent expert team to dissect the entire structure and produce a detailed 10 -12-page analysis usually within a month of each request.

Our Value Proposition for Pension Plan Sponsors

Our Investment Governance Reviews provide a detailed assessment of your entire investment process. We assess the quality of services provided by your investment consultant. We review your portfolio construction and compare it to your investment policy statement. We review your board investment committee activities and reporting packages to see if your process is sufficiently agile yet comprehensive.

We assess the quality and workloads of your staff, to ensure that your investment process is being managed with the care you would expect in an institutional setting and to propose ways to improve the investment process. Moreover, the IGR is much less expensive than hiring a second consultant to monitor your portfolio. You benefit from our experience covering the investment consultants and OCIOs, and this benefit accrues to you in lower fees.

We are experts at assessing institutional consultants and financial governance processes, and we have helped clients address exactly the concerns we describe in this letter. We have also reviewed over 40 institutional investment consultants and can help you identify the strengths and weaknesses in your coverage from them. We possess strong capital markets backgrounds as well, and we have evaluated over 2,000 managers since 2003, covering virtually every asset class and investment style. Moreover, we have deep networks of experts developed over the last 30 years to ensure full product and strategy expertise. Our analysis is performed only by senior analysts. This team approach ensures than 90+ years of combined investment expertise is focused on your portfolio and your diligence.

We are an independent firm, a boutique that has NO conflicts and works SOLELY in the interests of the pension fund. We do not recommend investments and are paid only under retainer agreements with our clients, with strong NDA protections for those clients.

Importantly, we are not seeking to compete with your investment consultant. We have likely already evaluated them as potential candidates in our OCIO and institutional investment consultant search business, and we have a good understanding of their strengths and weaknesses. You can benefit from our expertise in those markets, because we offer a broader perspective on this market than you could possibly build internally from an occasional consultant search effort.

We look forward to speaking with you and answering any additional questions that you may have.

Want to learn more? Please contact Chris Cutler, Tom Donahoe, or Safia Mehta at 917-287-9551.