Growing economic uncertainty has investors around the world on edge and markets in free fall. Even a long-term investor like Scott Malpass, CIO of the University of Notre Dame, is treading cautiously. But Malpass, now in his 26th year heading the Midwestern Catholic university’s investment office, is sticking to the investment principles that have guided his decisions as he evolved the Notre Dame investment model and racked up a formidable 12.2 percent annualized return over the decades.
Malpass attributes much of his success to the highly motivated, 38-member team he has built, most of them Notre Dame alumni. In fact, half of his current employees were once students in a finance class he teaches. “It’s a very close team,” explains Malpass. “I hire my best students, and it works well for me to bring in young people and train them.” He also points to the advantage of working with only two investment committee chairs during his tenure. “They have felt that stability, consistency and institutional memory are really important.” The fund, now approaching the $10 billion milestone, is a far cry from the $453 million the new CIO started with in 1988. The endowment had a 19.7 percent investment return for its most recent fiscal year, ended June 30, 2014.
Earlier this month Senior Writer Frances Denmark caught up with Malpass in Chicago, a 90-minute drive from his office in South Bend, Indiana, to learn how he has been navigating the increasingly treacherous investment landscape since he last spoke with Institutional Investor, a year ago (see “25 Years Later, Scott Malpass Is Still Notre Dame MVP”).
Institutional Investor: Are you worried about the state of the world?
Malpass: I am always worried about macro and exogenous events that are hard to predict. As an investor, one needs to stay balanced and focus on having a quality portfolio and good liquidity to take advantage of dislocations when they occur. There is a significant amount of change going on in the world, which makes it more important than ever to abide by those principles.
People are more bearish on China these days. Are you?
China isn’t growing as fast as they want everyone to think, but I expect they will continue to provide reforms over time that will lead to more foreign investment. The transition from an export-led economy to a more domestic economy will take time, and won’t be easy, but they are pursuing policies to assist that movement.
Will Europe become attractive to investors again?
Europe continues to be challenged by differing views throughout the euro zone on what policies will be most affective for long-term recovery. The Europeans will continue to muddle through and be tentative for the next few years, which means economic growth will be very slow.
What are the opportunities and challenges in allocating capital with a $10 billion portfolio versus one that is $400 million?
The asset growth is certainly celebrated on campus, as it affects the amount we can spend on various programs. When I started, we were spending about $20 million a year and about 11 percent of the budget. Now we’re spending $300 million a year, and it’s between 25 and 30 percent of the budget. So the endowment distributions are having a much bigger impact on campus.
But with size come some challenges in terms of being able to still access smaller investment funds — take a big allocation but not be too big a part of the fund — because we make a lot of real small, niche-y investments, particularly in the credit areas, in venture capital. And we’re not afraid to do a $50 million fund and put $5 million in it, on the venture side, let’s say. On the credit side, particularly in these past several years, we had banks getting rid of nonperforming loans and smaller funds being raised to two, three, four hundred million. And now we’re $10 billion, so how much do we want to take of that?
Yes, there are some challenges. The advantages are outweighing any negatives in terms of us doing more co-investing now. We love to do more directs in general, particularly in real estate, where the pension community has always done a lot more directs, but endowments haven’t as much because of their smaller size. We can get into any partnership now. So there’s a lot of advantages of size, and I think those will continue and far outweigh the advantages of being much smaller.
The Notre Dame portfolio now has 45 percent of its assets in private equity, real estate and other funds with long lockups, and an additional 25 percent in hedge funds. How do you manage these lockups? Did the financial crisis force you to change?
It was a time to press on that issue. A lot of us had uncalled commitments approaching 30 percent of the fund, probably. Some were higher. We’re at 15 percent now, so despite a lot of commitments, we’ve had a lot of liquidity back and structurally feel good about it. It felt good at 30, to be honest, but it was hard to know how that was going to play out had things not improved and the Fed not stepped in like it did.
After the crisis, institutions developed more liquidity, tightened their liquidity policies focusing on lockups and fees and their managers’ terms — especially hedge fund managers — being tougher on those. Certainly, we have. We used that period to negotiate some new share classes with different fee arrangements, different structures for liquidity and better alignment of our interests. It’s hard to do that when things are going really well; you’re better able to do that when there’s distress. I was pleased that we were able to accomplish that with a lot of our hedge fund managers. It’s unfortunate that it took that kind of crisis to have that kind of leverage, even for a long-term good partner like us, but for the very, very top tier managers, that’s the way it had been.
How has the institutionalization of alternative investments impacted your investment approach?
When I started, venture capital was still a little bit of a cottage industry, and private equity firms were raising the very big buyout funds, which we never invested in. We always want to invest in small to middle-market companies or small buyouts. We have to work harder to find people and network, and it’s more international, more global today. We get there by continuing to build our team, our process and our sourcing abilities, and using the network intensely to find ideas. There’s a couple hundred thousand, probably, private companies that you could invest with, so there are a lot of good firms, a lot of opportunity. We were early in some of those areas. It was easier to know whom to try to work with. It’s harder today than ever before in some of those alternative areas.
Almost all of your investment team are Notre Dame alum. How do you manage to avoid what has been described as the IBM problem, when IBM continuously hired from within? They had very talented people, but they all spoke the same language.
It’s something that, as CIO, I’m constantly trying to be vigilant about. Don’t forget, we’re in the flow all over the world. Our partners are all over the world. They have very different networks than we have. So a lot of it is, we’re just constantly out there in a very different flow of information. Also, even though the core investment team is all alumni, they all have had very different experiences. Many of them had gone on to do other things first and come back. Not all were finance and accounting majors. I haven’t found that to be a problem so far.
You are known for your keen interest in emerging-markets investing. Where does the allocation stand today?
I believe a fund’s emerging-market strategy over the next 20 years will be one of the key decisions that a fund makes. We’re about 18 percent emerging markets, about half public, half private. There’s clearly a major shift going on between the developing and developed world. We started early, in 1992, but many others were doing it even before then and around that same time. You didn’t do very well in emerging markets for quite a while, but we have in the past ten years.
Has your approach to investing in emerging markets changed?
Our approach has definitely changed. We went from more global approaches to regional approaches, now to country approaches. As we build our team and have been able to get out and spend time in these markets, we have developed a great institutional memory and knowledge about the major emerging markets.
A couple of years ago, we took this a step further and put everybody in regional teams. We set out to visit 42 emerging markets, from the largest to some of the smaller ones, including some of what is called frontier markets. We put together a white paper for our board laying out what markets we thought we wanted to spend more time in or would be able to franchise in — maybe what markets we were not going to spend as much time in because they’re too small, they’re not developed enough — a hierarchy of how we should spend our time, because, as you know, it’s very confusing. There’s a lot to do. They’re a long way away. There are cultural differences and issues you have to be mindful of. We did a cost-benefit analysis of spending time in different places.
It was one of the best things that we have done to understand the landscape. You’re constantly learning. We’re still located in the U.S., and in Indiana. We’re not living in China or Brazil or India, so it requires a lot of travel.
What were the results of this project?
It was a nice reset in our thinking about how these markets might evolve in the next ten, 15, 20 years and gave us a foundation that we can now react to. As things change, we have our list of what we think of as the top markets. And as markets evolve or open up, we plug them in. We developed a matrix with a number of different indicators that we probably wouldn’t have been as knowledgeable about had we not had that very focused, intense project, which took over a year and involved the entire team.
At regular internal investment team meetings, held every other week for a couple of hours, there’s some update on one of six regions that we’ve assigned everybody to, so we can stay abreast of macro issues and manager issues. We continue to find very interesting people in those markets. I think we’re spending our time where there’s real bang for the buck and where we’re more likely to meet people who would meet the various criteria that we look for.
Where are you focusing the most attention?
We’re taking a long-term view of this. But part of a deal is with scale: Where can you get real money invested? Where can you find the right partners? So the top three would be China, India and Brazil. And then Africa as a continent, but more sub-Saharan Africa.
We’ve downplayed Russia. We spent a lot of time there in the ’90s and at one point thought that there could be a real opening up and a real entrepreneurial culture developing. But, of course, that did not happen and has been shut down. Today we’re not spending any time there.
Those would be the big three, but China, by far, is our biggest. We have about 8 percent in China, public and private. And everything else is 1 or 2 percent. There’s no big weighting otherwise. It’s spread out, but it’s evolving, and we’re watching it, and we’re going to continue to visit those places. We’ve talked about opening offices overseas, partly to cover emerging markets better. That will be an ongoing conversation, because it’s very complicated. But it’s a great question, and something that we continue to review.
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