When Brokerage Firms Meet the Yale Model

How brokerage firms overload their clients with alternative investments ... and how to fix it.

We recently wrote about the rise of the “Yale Model” of investing heavily in alternative investments, its widespread adoption by institutions and endowments, and most importantly, how this model broke down recently.  Several large universities were forced to raise cash and sell their private equity at a discount to meet their cash flow needs.

Unfortunately, the Yale Model has also been promoted to private clients by brokerage firms, exposing individual investors to the same risks that are affecting the most sophisticated investors.   Individuals can often be more exposed to the cash flow risks currently occurring in alternative portfolios than universities.  While we don’t hear about their problems in the press, they can be equally devastating to a family’s financial situation.    

This piece will explore the risks of overcommitting to a traditional private equity portfolio, and more importantly, how to invest thoughtfully in an attractive asset class in a more risk-controlled manner.

A Brief Description of the Yale Model

The “Yale Model” has long been considered the gold standard of investing for universities and non-profit institutions.   Pioneered by Yale’s Chief Investment Officer David Swensen in the 1980s, Yale invested heavily in illiquid, alternative investments and generally outperformed the stock market during his tenure.  This model was widely adopted by other schools seeking returns, with the average university holding 56% of its endowment in alternative investments as of 2024.

The Flawed Assumption in the Yale Model – Infinite Cash Flow

The Yale Model works well, if and only if an investor has the cash to meet all its commitments and does not need to rely on the alternative investments for its cash needs.  When an investor is overallocated to alternative investments, particularly ones with outstanding capital calls, they can put their entire portfolio at risk.

Investors making commitments to private equity funds typically commit a fixed dollar amount, which will be funded over a five-year period and distributed as investments are sold, typically over ten years.  Investors rely on estimated capital call and distribution schedules, often provided by the fund managers themselves, to build their cash flow models.   In a perfect world, distributions from older funds would pay for the capital calls on new funds in an ever-growing self-funding pool of private equity.  What happens when this model hits a roadblock?

Universities are presently being hit by several events, both financial and political.  The pressures on university cash flows include:

• Slower distributions from private equity funds in recent years.
• Financial market volatility.
• Lower contributions from donors.
• Actions from the Trump administration to reduce research grants.
• Higher tax proposals on endowment returns.

Universities are responding in several ways to address their cash flow crises.  Bloomberg reports that top universities have sold $4 billion of bonds to raise cash this year.   Harvard is reported to be selling $1 billion of private equity.  Even the originator of the Yale Model is not immune to the need to de-lever itself;  Yale is in talks to sell $2.5 billion of its private equity funds.

The under-appreciated risk to investors in alternatives should be clear now: large allocations to illiquid investments with large outstanding capital commitments leave investors highly vulnerable to changes in their cash flow.   The actions universities are taking to correct their overleveraged portfolios (issuing bonds to raise cash, selling some of their private equity portfolios at a loss) will have a meaningful negative impact on their portfolios.

Private Clients Have Different Risks to Their Cash Flows

Private clients have different, but significant risks to their cash flows that can cause their cash flow to flip from positive to negative, including:

• Loss of income from a job or business due to economic concerns.
• A client’s business may need a major capital investment at a given moment.
• Divorce, death, or a significant illness in the family.
• In times of market turmoil, distributions from private equity are slower than expected (sometimes even zero).
• Conversely, managers often call capital faster than expected from investors to take advantage of investment opportunities.
• The performance of the rest of the portfolio matters.  If it is fully invested in stocks and other risk assets, selling those assets at a loss to fund capital calls can be very costly.
• During market downturns, other areas of hidden leverage within a portfolio may become apparent. For example, option overlay strategies or “worst-of” structured notes that work well in calm markets can quickly turn toxic in bear markets.

Most private clients don’t have the financial resources that a large university does if they find themselves overcommitted to their private equity portfolio.  Therefore, families need to monitor the risk of overcommitting to alternative investments.

Why Do Brokerage Firms Encourage Their Clients to Adopt the Yale Model?

If the risk of overcommitting to alternative investments is so obvious, why do brokerage firms in particular keep recommending large allocations to them?   There are several reasons, including:

1. It sounds sophisticated – if the biggest universities in the country are adopting 50% in alternatives, why shouldn’t private clients also adopt a large weight?
2. Fees – Private clients pay higher management and performance fees on alternative investments than universities.  Importantly, the fees on alternative investments are higher than on other products that brokerage firms sell to their clients.  Commissions on alternative investments are often among the highest that a firm offers its brokers.
3. Rosy cash flow projections - Brokerage firms often provide their clients with estimates of cash flow contributions and distributions on each fund and aggregate them for their clients.  These projections aren’t often stress tested; they are designed to build a balanced annual cash contribution and distribution from a portfolio of funds.  These rosy estimates can create a seemingly perfect flywheel that encourages clients to continue committing to new funds, generating ever-increasing fees for the firm and commissions for the broker.

As a result of the aggressive sales pitches and misaligned incentives, we see a lot of brokerage firm client portfolios that are overallocated to private equity funds with outstanding capital calls.   This begs the question: Is there a better way to invest in alternative assets, or should they be ignored entirely?

How We Invest in Alternatives for Our Clients

Alternatives are an attractive asset class that can increase returns and diversify a portfolio.  However, we want to ensure that we build our client portfolios in a way that allows them to weather market volatility and any unforeseen cash flow eventst.

1. What are the core principles of our portfolio construction?

• Our firm is required to act as a fiduciary, not a broker.  We put our interests before ours.  We do not collect placement fees or commissions on private equity funds and alternatives.
• We therefore seek investments that maximize our clients’ financial returns, not our economic returns.
• We seek to build a thoughtful, diversified portfolio that limits our clients’ risk to untimely capital calls.
• We recognize that clients’ lives can change - and that being able to sell an alternative investment portfolio is an important consideration.

2. What kind of funds do we use in our clients’ portfolios?

• We seek to diversify types of underlying investments across private equity, venture capital, private credit, and hedge funds.
• We concentrate on fully funded evergreen funds, such as interval funds, private funds, and private BDCs.  These are permanent capital vehicles, with periodic liquidity for a portion of their portfolio.  Note, there may be some strategies where traditional partnerships are appropriate, but we would be very mindful of them as a percentage of the portfolio.
• Evergreen fund investors benefit from being entirely invested from day one of the investment.
• We try to understand how each fund makes its investments and what its investing edge is.  For example, are they good at secondary private equity investing, are they a preferred lender to middle market buyouts, etc?
• We pay attention to the fund level liquidity term and how the fund’s underlying investments generate the cash flow that would be needed to meet redemptions.  Some sectors have gotten illiquid in the past (e.g. BREIT and Starwood REIT in the real estate space).  It is entirely possible that other sectors or funds may have liquidity issues in the future.

3. How can we help clients who have committed too much to alternatives?

• If a client has a portfolio of funds at a brokerage firm and is worried about it, we recommend first stopping committing to new funds.  Perfect cash flow projections work well in an ideal world, but don’t account for real life events that can happen to private clients.
• Second, we can analyze your portfolio and balance sheet holistically to see how to generate more liquidity.
• Finally, as your investment portfolio gets more liquid, we would change your approach to investing in alternatives in a more risk-controlled manner as outlined above.

Reach out to your Farther advisor if you have further questions about alternative investments and whether they fit into your portfolio.   If you have an alternative investment portfolio you would like reviewed, your advisor can work with our Advisor Investment Strategy Group to analyze your portfolio.