Conservative investments paired with choice alternatives have sustained not-for profit Hartford HealthCare’s $3.3 billion hospital fund through market swings over the past eight years, according to Chief Investment Officer David Holmgren. The endowment currently invests around 10% of its portfolio in private equity (PE), while its direct peers invest roughly 30% in the asset class, Holmgren told Institutional Allocator. “We perform similarly to a top-tier endowment, but in a high-level rollup of assets, we look far more traditional,” he said.
Comparatively Low PE Allocation
“I think our smaller weight to PE allows us to more dynamically adjust our preferences within asset allocation,” Holmgren said. For example, “we haven’t committed to a large mega-buyout since the Brexit vote—we’ve had our own worries on whether there are cross-border risks to transactions, and the concept of the rise of populism terrifies us,” he said. “We have a different lifecycle to our PE because our preference is now towards a lower- to mid-market buyout in select countries.”
The fund is 100% actively run by approximately 90 managers and has “more than one” manager to which it pays higher-than-average fees, Holmgren said. “Our endowment is managed to a high-net-return objective of an 8% hurdle rate and that requires us to be willing to pay up for what we want, and we only do direct investments in partnerships [with] our managers,” he explained. He declined to comment on the fees the fund pays to its managers.
A Sharp Focus on Income
Eighteen months ago, the endowment began to shift away from a total-return primary objective to an increased focus on the fund’s income component, Holmgren said. “We wanted to think increasingly about securing the payout—we want to be able to meet those liquidity needs,” he said.
For example, the fund does not hold any gold because there’s no income produced by the holding of that metal, Holmgren said. “We’ve managed the whole economic hedge class from the perspective of real asset-backed, income-producing assets. And, in the past two years, more short-duration items like aircraft and shipping,” he said. “On the other end of the spectrum, we’re really keen on social infrastructure, which has a 12- to 13-year lifespan. Broadly speaking, we rarely do co-investments, but are active within in the real assets category, such as in road projects or energy projects.” Holmgren hopes to bring real assets up to 15% of the total fund from 13% by the end of next year.
Even within “risk reduction” which accounts for 30% of the total fund, Hartford’s investment team gives a disproportionate weight to income producing assets. “We went overweight into private debt and private credit three years ago, and now that we’re likely at the tail cusp of our cycle we expect to stop re-ups in the near future. There are way too many investors going heavy now at the private credit space, which is a little scary,” he said. “We’ve been trying to navigate this flood going a little bit down market, more esoteric, more off-run and globally diversified as well as looking really at non-sponsored deals, such as corporate loans to a Brazilian distressed company or an Asian consumer products company looking for expansion capital or an American media company restructuring its balance sheet. Our last commitment to a sponsored private credit fund was about three years ago.”
The broader industry’s piqued interest in private debt and credit has to do with fixed-income substitution, Holmgren asserted. “Investors are looking at income from different perspectives, and are hyper-aware of price instability and price risk of assets,” he said. “A lot of people don’t understand that fixed income can go down—there might be a safety play in fixed assets, however, there’s a valuation risk from rate movements.” So Holmgren is preparing the fund for the pendulum’s back swing, which he thinks may occur as early as next year. “The fixed- income substitute trade (ie. looking for yield) has driven allocators to private credit, however, we are getting perhaps to the tipping point when fixed-income assets return to being a positive relative valuation (ie. at the end of the cycle, holding duration is no longer risky, so the buying rate sensitive assets becomes prudent; again the reference is simply that unlike everyone else avoiding duration we are now getting ready to start adding duration back into the fund perhaps as early as next year,)” he said.
The Unfunded Commitment Cliff
One of the most sensitive issues in the industry right now is the handling of unfunded commitments, noted Holmgren. “Right now, every CIO is terrified of the unfunded commitment cliff,” he said. “We’re still researching private equity (PE) matching strategies, or whether we can secure a matching program between our underfunded commitments to any correlated liquid vehicles—it’s very interesting for portfolio construction dynamics,” he said.
Liquidity pressures on institutions with large outstanding PE commitments may not turn out so well, for example, during a down market being exacerbated by forcing selling to meet capital calls, especially if the institutions experience a slowdown in PE distributions, Holmgren predicted. The worry is further magnified by the recent outperformance of the PE class, especially in venture where the managers are deciding to hold on longer before exiting. “Look at how well everyone’s done with their appreciation in tech PE investments in companies like Uber. As our fund’s value goes, so too does our needed cash position to make the spend on our funds, which is generally a percentage, for example, 4% of our fund value. As our fund value goes up, we need more cash to meet payouts,”said.
With the recent slowdown in distributions relative to valuations, and, at the same time, an increase in commitments to the PE space, almost every CIO is in the same boat—worried about the potential cash squeeze on their fund, Holmgren cautioned. “It is perhaps today’s biggest risk that we [CIOs] see from our seats; and either way, liquidity management is on the top of every office’s to-do list.” Interestingly though, Holmgren added: “The recent situation in large unfunded commitments relative to valuations has started a whole new industry that didn’t exist a few years ago—the rise of liquidity markets for venture distributions, which has all sorts of new issues coming out of it.”