Cerulli: CIC moves to endowment model

Cerulli Global Edge, July 2014

KEY TAKE AWAYS:

• The endowment model is the approach taken by U.S. university funds such as Harvard and Yale, which are known for their high allocations to alternative assets and private equity in particular.
• The move can be seen in recent investments, and comes in tandem with a trend for greater allocation to external asset managers with expertise in these areas.
• However, U.S. endowments are paring back their private equity allocations, albeit to still very high levels.

One has to wait a while before word of any changes at the China Investment Corporation (CIC) makes its way to the outside world. Anything as significant as a switch in strategy or allocation is disclosed in the fund’s annual reports, and it’s fair to say that CIC is not in a rush to put those out. The most recently available full-year report covers 2012, and includes a little remarked upon but significant change. It is only beginning to be felt by fund managers today, but will be increasingly evident following the appointment of a new chief executive officer (CEO) earlier this year.

In 2012, we now know that CIC conducted a five-year review of its performance and that of other institutional investors. It then decided to move to a new allocation strategy, based upon what it calls “the endowment model.” Although this is an inexact term, it is usually considered to be synonymous with the endowment funds linked to the big American universities, notably Harvard, and in particular, Yale.

Learning from experience

To understand what this means in practice, it is useful to take a close look at CIC’s background. In the early days, CIC got a lot wrong. Investments during the global financial crisis, notably in U.S. institutions such as Morgan Stanley hurt it badly—although that particular investment did eventually turn a profit. In 2008, the first reported year of returns, CIC logged a full-year loss of 2.15%.

Stung, it changed tack. In the following years, CIC showed a clear focus on frontier commodity assets, such as mining businesses in Mongolia. Then, as more and more of its money was put to work, a more sophisticated and balanced allocation of assets began to evolve. The 2012 decision to shift to the endowment model is part of this evolution.

NOTABLE: By the end of 2012, 32.4% of CIC’s assets were held in long-term investments and 12.7% in alternatives—that is, over 40% of its funds were in non-traditional assets.

But what does it actually mean? Yale’s endowment fund is characterized by the heavy use of alternative assets, most obviously private equity. And, over time, one can see how CIC has started to prioritize alternatives. In 2012, it invested in infrastructure, agriculture, and other assets that generated steady returns. It also developed a new model for investment in private equity, buying stakes in the U.K.’s Thames Water and Heathrow Airport Holdings.

Getting a precise handle on this is tricky because of CIC’s allocation terminology. In 2011, 31% of its assets were in long-term investments, 25% were in diversified public equities, 21% in fixed income securities, 21% in alternatives, and 11% in cash. At CIC, it is understood that ‘alternatives’ really means hedge funds. Other alternative assets such as private equity and infrastructure appear in the ‘long-term investments’ category, although CIC says this also includes energy, mining, and real estate, in some form or another.

In any event, by the end of 2012 these alternative categories – already substantial – had grown further. 32.4% were in long-term investments and 12.7% in alternatives—that is, over 40% of its funds were in non-traditional assets.

CHART 1 – Investment Objective 2012

This is worth comparing with Yale. In 2012, the university’s target allocation for private equity was a mighty 35.3%, although this dropped back to 31% in fiscal 2014. So in many respects, CIC is already beginning to look a lot like one of its role models.

The Dynamic Duo

Much of this can be put down to two particular members of staff: Gao Xiqing, the founder and president until he stepped down and retired earlier this year, and Li Keping, the man Gao recruited as chief investment officer (CIO) in 2011, and who took over as CEO in January this year. The two are long-term colleagues: they worked together at the National Council for Social Security Fund, China’s biggest state pension and an interesting institution in its own right. According to the Chinese fund management specialist Z-Ben Advisors, the pair joined forces to increase the fund’s overseas allocations. One hired the other and the transition between the two was smooth. It is however important to note that the change to the endowment model came not long after Li’s appointment as CIO, and he is expected to be a strong driver of CIC’s future strategy.

NOTABLE: With US$575 billion assets under management, CIC is one of the biggest sovereign wealth funds in the world, and has the potential to become the biggest within the next five years.

International fund managers should be watching this with more than curiosity, for two reasons. For a start, CIC – with US$575 billion (€421 billion) assets under management (AUM) at the end of 2012 (although about one-half is in local bank holdings held by its Central Huijin subsidiary) – is now one of the biggest sovereign wealth funds in the world. It would also be no surprise to see it become the biggest within the next five years. Secondly, and perhaps more significantly, after an initial period during which CIC steadily increased its in-house investment expertise, the proportion of funds that are managed externally is actually increasing. In 2009, 59% of the fund was managed by external managers, and by the end of 2012, this figure had risen to 63.8%.

CHART 2 – Portfolio 2012

The conclusion must be that for foreign asset managers with a proven track record in alternatives – be it hedge funds, infrastructure fund managers, private equity groups, or institutions that can act as a broker for direct investment – there is a terrific opportunity in China now. As CIC gains consistent if irregular asset injections in the year ahead, there is going to be more and more money for those fund managers to chase.

The U.S. example

There is however one aside: if Yale and Harvard are the role models for CIC, it is interesting to note that the American endowments are actually reducing the sorts of investment that CIC is increasing.

CHART 3 – Yale

Yale cut its target allocation for private equity in September—although a reduction to 31% of the portfolio is still far more than almost any other diversified investment institution. In the same month, Jane Mendillo, president and CEO of the Harvard Management Company, which oversees the US$32.7 billion endowment fund, sent out a note. In it, she complained that private equity had been underperforming the equity markets. “When we invest in private equity, we lock up Harvard’s money for multiple years. In exchange for that lock-up, we expect to earn returns over time that are in excess of the public markets—an ‘illiquidity premium’.” The inference was that this illiquidity premium was not being received. In the short term, Harvard’s approach has been to hire a new managing director for private equity to improve performance, rather than to pull back from the asset class. There is, however, no question that the U.S. endowments are taking a closer look at the performance of alternative assets.

NOTABLE: The proportion of CIC’s funds that are managed externally is increasing. In 2009, 59% of the fund was managed by external managers, and by the end of 2012, this figure had risen to 63.8%.

Does that mean CIC is heading into asset classes just as U.S. endowment funds are heading out of them? Hardly. The cuts in allocations by the two Ivy League universities are modest, and a commitment to alternatives is still much greater than it was just five years ago. But it does appear that the strategy of the U.S. endowments and CIC could be remarkably similar in the years ahead. For the moment, that’s very good news for well-positioned international asset managers.

Box: Central Huijin

One distorting element of the CIC’s asset picture is the presence of a subsidiary called Central Huijin Investment. This is quite different from the rest of the enterprise. While CIC broadly exists to diversify holdings outside China, and has no domestic investments, Central Huijin is a holding company for the state’s stakes in the Big Four national banks (Bank of China, ICBC, CCB and Agricultural Bank of China) and the China Development Bank. Central Huijin is a wholly owned subsidiary of CIC, with its own board of directors and board of supervisors.

It is also an incongruous distraction: its reporting currency is the RMB, whereas the rest of CIC uses the dollar; its performance is not considered when CIC publishes its own performance numbers, yet its assets are included when CIC states its overall asset position. The latest annual report refers to a “strict operational firewall” between the business activities of the two parts of the fund. They even have different methods of consolidating the financials of long-term equity investments.

So why have them together at all? It is rumoured that Li Keping intends to separate them completely so that Central Huijin will no longer be part of the CIC. For foreign asset managers, this will not make a huge difference, except that it will be easier to quantify the CIC’s international asset position and to establish where the opportunities lie. It will, briefly, demote the CIC down the unofficial league table of the world’s biggest sovereign wealth funds – but not, one suspects, for long.