The Yale Investments Office will soon select its first round of Prospect Fellowship recipients, where Yale will offer working capital, investment capital, and training to a cohort of five emerging managers. I’ve been thinking about why Yale launched the Fellowship and what might happen as it rolls out. Yale, emerging managers, and other allocators have opportunities and risks arising from the program, including some potential unintended consequences.

For those short on time, here’s a summary:

Yale’s motivation. Yale’s endowment is driven by generating outstanding investment results. Publicizing the Fellowship also serves as a branding exercise to position Yale as a go-to source of capital for the next generation of investment founders.

Yale’s risk. Despite Yale’s amazing success backing early-stage funds under David Swensen, this program is a different animal. Yale will be deluged by inbound interest, most of which will be of lesser quality than Yale has reviewed historically. Yale may struggle to process the volume gracefully and repeat its past results.

Manager’s motivation. Early-stage managers will see a rare opportunity to receive capital and mentoring from a world-renowned investment organization. Should the manager earn Yale’s confidence for a larger allocation, it will be well on the way to building a successful business.

Manager’s risk. The history of other emerging manager programs implies that most of the Fellowship recipients will not graduate to Yale’s main portfolio. An applicant may want to consider the negative signaling effect of that outcome on their business and career.

Other allocators. Yale provides cover for more institutions to create similar programs and for those with existing programs to continue. Others may look to follow Yale and invest with managers who graduate into Yale’s portfolio, although few are as fast followers as they once were.

Then what? Yale’s support of early-stage managers will be fascinating to watch. On the one hand, Yale’s selection history, experience with early-stage funds, and network of high-quality managers to assist may combine to create something special. On the other, the open application process, inevitable failure of some Prospects, and consequences for Yale and those managers may compel changes in Yale’s emerging manager program.

Let’s examine each in detail, starting with a brief history of Yale’s investments in early-stage funds.

History

David Swensen was extraordinarily successful in backing early-stage investment talent. He had an unparalleled eye for unproven managers across asset classes, and Yale’s manager roster today reflects decades of practice in getting it right.

David invested with hedge fund managers Tom Steyer at Farallon, Nancy Zimmerman at Bracebridge, and Steve Mandel at Lone Pine on or close to day one. He backed international equity managers Hillhouse, Overlook, and Silchester when they managed next to nothing, and he was perhaps the first institutional investor in a list of venture capital and private equity firms that constitute today’s most well-known brands.

The Yale Investments Prospect Fellowship is a public expression of Yale’s long held investment methodology and an opportunity for Matt Mendelsohn and the current generation of the Yale Investments Office to make its mark on the industry.

Yale’s motivation

The Yale Investments Office seeks to provide high inflation-adjusted returns to support current and future needs of the University.^[1] It may address adjacent desires of its constituents, like diversity, but make no mistake about it – Yale invests for financial rewards and does not sacrifice returns for social causes.

As such, Yale will look to the Prospect Fellowship as an opportunity to enhance its returns. Think of the program as a venture capital portfolio: Yale will make small investments in a series of managers – the $50 million commitment to each manager is just 0.12% of the Yale endowment and the initial cohort of $250 million will comprise 0.30%-0.60% in total. From there, Yale can significantly increase its allocation to the best managers. If we assume 1% is Yale’s core position size, it might give a successful emerging manager another $350 million over time. Any losses on a relative or absolute basis from Fellows who do not clear Yale’s bar can be made up by outperformance over time from those who do.^[2]

A secondary motivation for Yale is to become the capital provider of choice for future generations of investment founders. Yale held this imprimatur under David Swensen. As part of that process, Yale’s past success with emerging managers resulted in long term partnerships that consume a lot of its capital. Other organizations, like MIT under Seth Alexander and Duke under Neal Tripplett, have been more active in the emerging manager space in recent years. The Fellowship is a tool to help Yale re-establish its brand as the go-to investor for founders.

The public proclamation of the Fellowship may elicit desirable founders who may not otherwise have reached out to Yale. Spin-outs of top investment managers may find Yale an attractive partner, especially knowing that Yale does not ask for economics in the newly formed business.

Yale’s risk

The Fellowship comes with a series of risks to Yale, both for performance and reputation. Yale may find the Fellowship brings in more volume and less quality than it is accustomed to reviewing, resulting in an inefficient use of its time and reduced odds in finding a gem. Additionally, selecting a cohort of managers simultaneously is very different from investing opportunistically, and training them is not something Yale has done in the past. When things don’t work out, Yale will also need to unwind positions on its own.

The Fellowship will have a firehose of applications the likes of which Yale has never seen. I experienced an ongoing, massive volume of inbounds from prospective hedge fund managers in my time at Protégé Partners. Similarly, the RAISE Global conference received 900 applications from emerging venture capital managers this year.^[3] Those examples come from just two of Yale’s seven asset classes. I imagine Yale will want to be diligent and responsive when considering all applicants, but the volume will make it difficult. It feels like Yale’s college admissions process, with a 5% acceptance rate after a quick decision process off limited information.

In a resource-constrained office, the time spent with applicants and Fellowship recipients may be better spent sourcing and working with managers in the rest of Yale’s portfolio. That opportunity cost is difficult to measure and will be an ongoing criterion for Matt and the team in evaluating the program’s success.

Beyond the quantity of applications, the Fellowship is unlikely to yield comparable quality of emerging managers than Yale considered in the past. David Swensen built a network of top performers and leaned into multi-decade relationships to source the next generation of talented founders.

Next, the investment process required by Yale for the Fellowship is quite different from what it has done in the past. Yale held meetings over many months or years with prospective managers before writing a check under Swensen. In contrast, the Fellowship compels Yale to select five managers in a short period of time with only a brief application to review. The forced allocation of capital is not as effective as waiting patiently for the best opportunities to arise.

After selecting its Fellows, Yale will seek to train them with course materials, perhaps modeled off Y Combinator’s support of founders. Training entrepreneurs to build a business includes repeatable and teachable components like recruiting talent, developing sales funnels, and researching product-market fit. Yale and its managers have a deep understanding of best practices, but it’s less clear that the art of investing can be transferred through a course. If not, how will that reflect on Yale’s reputation as a leading emerging manager backer?

Lastly, Yale will need to consider what happens to its assets when a Fellow does not graduate to its main portfolio. In any strategy outside of the public markets, Yale will need to unwind illiquid investments after the Fellow responsible for the investment has departed. It’s another necessary skillset Yale may not have had to develop previously.

Emerging manager’s motivation

The Fellowship provides a rare opportunity for an emerging manager to get discovered. Yale will be a valuable partner, steering managers to industry best practices and service providers. Twenty years ago, a study indicated that 50% of hedge funds fail because of operational issues.^[4] I never agreed with the conclusion, but regardless, it’s safe to say Yale can help mitigate that risk. On the investment side, Yale can pull from a first-rate roster of managers to mentor Fellows as well.

Should an emerging manager gain an allocation from Yale beyond the $50 million in the Fellowship, their likelihood of building a successful firm will soar. The manager can expect Yale’s endorsement throughout its life cycle. Yale will help the manager structure their organization for success and introduce them to similar-minded LPs.

Additionally, Yale does not ask for an economic stake in the manager’s business. Instead, Yale seeks to align the manager’s interest with all investors, including fair terms and constraints on the manager’s growth. Those tradeoffs are more attractive than the asks from most other sources of start-up capital.

Emerging manager’s risk

Despite the obvious opportunity, the Fellowship comes with a potential cost to managers. Prospect Fellows face an uphill climb to create a viable investment firm, and the consequences if they don’t may be significant.

An emerging manager program is not a new idea. We can look at the fortunes of others to consider what might happen to Yale’s. Texas Teachers Employee Retirement System has run an emerging manager program for 20 years. CIO Jase Auby described on a recent Capital Allocators podcast that TRS has backed 190 managers with a similar $25-50 million. Jase sees the program as a huge success – returns have met targets and 12 have graduated to its core portfolio.

That’s worth reiterating. Texas TRS deems 12 out of 190 a success. What does that imply for Yale’s Prospect Fellowship?

Most Fellows will experience failure. The TRS data implies that one of Yale’s lucky Fellows will graduate to its core portfolio every three cohorts. In other words, 14 of 15 won’t make it. Making matters worse, the 93% who move on may carry a Scarlet Letter of Yale’s rejection. It could be a tough road forward from there.

The ramifications of negative signaling from Yale are not new. When Yale pulled its capital from existing managers historically, many struggled to survive and particularly those with a boutique, single-product firm that Yale favors.^[5] Imagine how much harder it will be for a manager to build a business when they never had outside investors in the first place.

Even if Yale wants to continue the relationship, the $50 million commitment is subscale for most strategies. An early-stage venture capital or small cap public equity manager may be ready to roll with $50 million, but managers of real estate, private equity, or hedge fund strategies usually require more capital from outside investors to create a viable business.

Yale’s criteria for promoting or cutting a Fellow is a non-trivial, qualitative assessment. How and when Yale will decide to double down or withdraw its capital will be essential to the fortunes of Fellows.

Other allocators

Yale’s announcement is a strong positive for the community of allocators. First, the Yale imprimatur can help sway a governance board to adopt a similar program when that board might otherwise be overly concerned about risk. Second, many institutions already have their own version of Yale’s Fellowship and will benefit from Yale’s endorsement to further their efforts.

On the investment side, most CIOs will embrace the opportunity to wait and see which managers Yale supports in size. They are happy to outsource wading through large fields of chaff and see if Yale finds wheat.

Followers among allocators move more slowly and independently than in the past. Yale’s support will be a positive factor in the decisions of others, but many more allocators invest in undiscovered managers and those inclined to follow have a longer list of peer recommendations to consider. Follow-on investments are harder to come by that they once were.

And then what?

The long-term success of the Fellowship will be determined by both results and perception. Yale may elicit great spinouts that it might otherwise not have seen, but I imagine those will be dwarfed by the many other emerging managers keen to receive Yale’s capital.

For the Fellowship to generate significant enough returns to justify continuing the program as designed, Yale must believe that its mentoring can meaningfully move the needle on performance. Yale may have better experience than anyone with early-stage managers, but it’s unclear if Yale and its managers can impart enough wisdom to help boost returns of a Fellow to the upper echelon of the industry.

Yale’s results will not dictate the program’s fate alone. The negative signaling for emerging founders who do not get promoted may bring unintended consequences. As many of the Fellowship managers return to the market and struggle without Yale’s backing, Yale may find it more difficult to be seen as an emerging manager allocator of choice.

This is an exciting endeavor that comes with opportunities and risk for both emerging managers and Yale. I applaud Yale for experimenting with this initiative, but I’m concerned that unintended consequences will outweigh the benefits.