The $1.1 billion University of Utah endowment is currently talking to several “specialty investment” managers with an eye toward investing in the niche asset class in 2019. “Based on our research, some of the attractive non-correlated strategies we’ve identified are: litigation finance, life settlements, and oil and gas royalties,” said Mark Waite, director of endowment investments at the University. The Utah university endowment has also researched investment in catastrophic reinsurance and royalties from companies in the healthcare, music and entertainment industries. The endowment has no stated investment amount in mind, at this time.
For the past 18 months, the endowment’s investment team has been doing due diligence on both the asset class and on specialty managers that offer these types of funds. “We decided we should focus on the ones that offer an attractive risk-return opportunity set, and therefore, we would be rewarded by devoting some time and research to it, where we can make a couple key investments,” Waite said. The move is part of the endowment’s overall push to better diversify its portfolio to protect against higher market volatility and big market declines. “In our view, capital markets are in a vulnerable spot with high prices and high correlations across the board, including in real estate, stocks and private equity/venture capital. On the private side we’ve seen massive capital inflows and managers are sitting on record amounts of dry powder. Purchase price multiples are extremely high and deployments have slowed. All of these factors are worrisome,” said Waite. In response, the endowment has been “looking for investments with idiosyncratic risk, which can offset the market or system risk present elsewhere in the portfolio.”
Waite noted that during the great financial crisis, “everything dropped together, and since then everything has risen together. It’s hard to get meaningful diversification, so we wanted to explore some non-correlated areas.” Given the current low-interest rate environment, securing income has been challenging, prompting the U. of Utah endowment to look for investments that are unrelated to typical fixed income securities, he said.
Of all the “specialty asset” classes it is considering, litigation finance is at the top of the University of Utah’s wish list for next year. “We think it’s the most compelling area, and it has an attractive risk-return profile,” said Waite. “The returns that the top managers are generating in the space are 30 plus, net IRR (internal rate of return). We like that they are non-correlated, as you are essentially underwriting the outcome of the legal cases, which has no correlation to stock and bond markets or any financial markets,” he noted. “It’s also recession resistant, regardless of the global economy—there is always going to be litigation matters,” Waite said.
Waite also noted that most commercial cases settle on average in 2.5 years, so the average investment duration for this type of investment is, typically, less than three years. That time frame is much less than for private equity or venture capital investments that can go on for five to seven years, he said. “So, we like that they are able to invest and work through the cases and that you will get your money back in a shorter time frame to lessen the risk.” Because some cases do go on for many years, “the duration on the fund is typically a 10-year structure, similar to that typically seen in a limited partnership investment, but [most cases] are settled sooner than that,” Waite said.
Another area of high interest for the endowment is life settlements, or investment in life insurance policies. “We think it’s an attractive area,” Waite said. As policy owners age and leave the work force, they may find they no longer need the policy. At that point, the policy owner can continue to pay their premiums, surrender their policies and redeem the value, or have a third party purchase the policy and take over the premium payments.
“There’s about $100 billion per year of whole life policies that either lapse or surrendered each year. A good portion of these policies could be acquired by life settlement firms, but most of these policy holders are unaware that they could have sold their policy instead of letting it lapse or surrender,” said Waite.
Returns for the asset class have come down a bit over what they were five years ago. At that time, “you could expect returns in the mid-teens, net IRR, and now they are down to 10% to 13%. But you also have low standard deviation; it’s about 5%, so you get a very attractive risk-adjusted return on them. Also, these investments are non-correlated, so they are recession resistant. That’s why we think they can be very value additive to a portfolio,” Waite added.
Oil and gas royalties
The third area of prime interest for the university’s endowment in the specialty sector is royalties. In particular, “we like oil and gas royalties, because we think they have an advantage over royalties in the music industry in that the future demand for oil and gas is pretty constant,” said Waite. While the prices for commodities will fluctuate, the demand for oil and gas should remain steady over the next 20 to 30 years, he said. “So, if you can find mangers that can acquire oil and gas royalty rights and structure good contracts, we think the return potential there can be pretty attractive,” Waite said. Top managers in the space have generated high-teens net returns,” he noted.
Other sectors which generate royalties are healthcare and entertainment. “There are healthcare royalties where you are buying the future cash stream on a prescription drug product,” Waite explained. “The driver of that is that it is very costly to develop a drug and to go through the FDA (Food & Drug Administration) process to bring the drug to market. Often these drugs will change hands, maybe an initial group develops it and will take it so far in the FDA process and then sells it to another party that then takes it further. But these companies need money to generate for their R&D (Research & Development) efforts. So it’s become a growth industry during development,” he said.
In the entertainment sector, royalties are often paid on revenue from music and movie sales. When investing in this sector, “you are paying a cash amount for the future expected cash stream on a movie or piece of music from an artist,” Waite detailed. However, it’s hard to predict what consumers’ future interest in a movie or piece of music will be. “So there is a certain amount of unpredictability about what the future cash flows will be. That is the key risk with those types of royalties.”
Choosing the right manager
The University of Utah endowment’s investment team is currently speaking to specialty managers who run private funds that offer structures similar to that of a private equity fund, as opposed to hedge fund and private equity managers, who may dabble in the space, but have a much broader investment mandate. “We are investing in managers that are dedicated mangers and are only doing these types of strategies. We want to find mangers who are dedicated to the space and not some generalists and large hedge fund shops doing a variety of things,” Waite said.
The endowment is currently conferring with its consultants about these specialty products, however, given the uniqueness and newness of these investments, the consultants may not have the time or expertise to do a deep dive into this niche area, Waite noted. That puts the burden more on the investment staff. “We have to do a lot of research on our own, so it takes time for us to feel comfortable in the space and to do the due diligence [that is needed],” he said. “We also need to do the due diligence on the managers and to identify who we think the top players are,” Waite added.
Once the specific investment choices have been identified, the endowment will likely include them in the diversifying strategy portion of its portfolio, which is currently comprised of hedge fund investments. “We will start out with two or three investments and gradually build out that part of portfolio and continue to look at and make investments into these non-correlated areas,” Waite said.