As institutional investors, university and college endowments have several characteristics that harmonize with the private equity investment timelines, such as longer return horizons and indeterminate liabilities. So, it should come as no surprise that in 2019, endowments continue to show interest in private equity and similar committed capital-style investment pools with long-term return objectives. In fact, a December 2018 survey of endowment and foundation decision-makers by national investment consulting firm NEPC indicated that a majority of endowment investors expect private equity returns to outperform other investment classes over the next few years.
In connection with the sustained interest in private equity investing, endowment investors have become more sophisticated and assertive in obtaining investment terms that suit their unique interests and protect their rights, which is especially important in closed-end investment funds that do not provide liquidity for an easy exit.
U.S. endowments were some of the first institutional investors to prioritize environmental, social and governance (ESG) principles in their investment portfolios. Historically, the ESG movement focused on restricting the types of investments that a private equity fund could make, such as precluding investments in fossil fuels, firearms or tobacco. However, recent trends in ESG investing have aimed more at adopting general sustainability principles with more flexibility, partly due to concerns that specific prohibitions could inhibit returns.
In seeking a more holistic approach to sustainable investing, endowments may request a commitment from private equity managers to proactively consider ESG factors when looking at investment opportunities. As an alternative to a flat prohibition on certain types of investments, an endowment investor also might obtain the right to be excused from investments in violation of its ESG principles. Endowments have also become key investors in the impact investing space (including opportunity zone investing), where managers invest assets in pursuit of social or environmental goals alongside a positive return.
As special negotiated terms have become common in private equity, endowment investors have become more assertive and successful in receiving preferential terms for their investments. Once viewed as an incentive for early closing or very large investors, certain basic side-letter terms have become almost ubiquitous in institutionally-offered private equity funds. Many common preferential terms are available to endowment investors even at smaller commitments, including the following:
- A “most favored nation” clause providing that an endowment can select any more favorable terms granted to other investors at the same or smaller investment size.
- Special notices relating to key personnel, adverse regulatory proceedings or legal actions impacting the manager or the fund, financial reporting or conflicts of interest.
- Required disclosures regarding placement agent fees and any compensation paid in connection with a fund’s offering or the solicitation of investors.
- Rights to elect to be exempted from certain fund terms that may conflict with an endowment investor’s internal policies (e.g., binding arbitration, or the use of certain alternative investment vehicles).
Endowments continue to face increasing demands for transparency into their investment portfolios, whether from trustees, alumni and donors, or student groups. Moreover, endowment decision-makers rely on accessible and intelligible investment data to make efficient and informed investment decisions about their portfolio. These pressures have led endowments, along with other similar institutional investors, to push for increased transparency from underlying private equity managers, often in the form of increased reporting and standardized data sets.
In addition to the standard reports already provided by private equity funds, endowment investors might require that managers include a description of any borrowing by the fund, any reserves for claim or liabilities, amounts applied to offset management fees, or detailed information regarding new or particular kinds of fund investments. Endowments may also request that a manager commit to providing reporting on fees and similar matters on the standardized forms preferred by institutional investors. The Institutional Limited Partners Association (ILPA), for instance, has published certain templates for reporting and other purposes. These types of tools can help decision-makers enhance the consistency and usefulness of their investment data to respond to the demands they face in managing an endowment investment portfolio.
Overall, endowment investors continue to look at private equity investing with general optimism. For their part, endowments are becoming increasingly sophisticated and engaged with managers and, as a result, managers have demonstrated a willingness to accommodate and develop products and options that appeal to endowments. When evaluating new alternative investments, endowments should consider pursuing the special terms and rights that are increasingly commonplace in the market and could enhance and protect their investments in the long run.