Kristin Gilbertson | Weathering the Storm

The present financial crisis has its roots in the unprecedented credit expansion of the last several years. Relaxation of lending standards, over-reliance on flawed risk models, lack of regulatory oversight and a culture of excessive risk-taking paired with a lack of personal accountability have put our entire economy in grave peril.

Banks made a lot of bad loans to companies and individuals, and the damage was compounded when these bad loans were levered up and sold to both institutional and retail investors in the form of SIVs, CDOs and CLOs. Insurance companies wrote protection on these instruments but underestimated the risk, undercharged for the insurance and did not adequately provision for losses.

This has severely weakened if not bankrupted a host of investment banks, commercial banks and insurance companies and threatens still more institutions in the years to come. Through securitization, the damage has spread to ordinary individuals and institutions through their investments in fixed income and money market mutual funds.

Counterparty risk became reality with the collapse of first Bear Stearns and then Lehman Brothers. And, what started as an increase in credit spreads a year and a half ago has now turned into a panicked race for the exit. Credit has dried up. Companies are finding it difficult to refinance their debt. Individuals are having trouble getting a car or a mortgage loan. And that in turn is beginning to impact the real economy.

Equities have fallen by 40 percent for the calendar year to date as investors worry that the recession will be long and painful. Historically safe bank loans are trading at levels not seen since the Great Depression as investors worry about rising bankruptcies. And prices of all securities are under pressure as the leverage everywhere in the system unwinds.

How does all of this affect the endowment?

Roughly four years ago, we made the decision that spreads were too tight, the market was underpricing risk and we weren't getting paid to take credit exposure. We moved our fixed income portfolio first into Government securities and then into Treasuries. At about the same time, we wound down our high yield investments.

Within our equity portfolio, we made a conscious decision to underweight U.S. financials. We migrated what had been a traditional deep-value portfolio to large cap quality names with higher return on equity, less economic sensitivity and low debt levels. And, we diversified internationally on fear that the U.S. consumer and the U.S. government were too dependent on debt and that the party could not continue forever.

Penn has long had a more traditional portfolio than many of our large endowment peers. Since my arrival four years ago, we have been building out a program in these asset classes but were very conscious about valuations and the flood of money flowing into the space. We have been slow and deliberate in putting money to work and did not race to catch up. Roughly 60 percent of the funds we have committed have yet to be called which means that our managers will be able to take advantage of vastly reduced prices. Even more importantly, we maintained an overweight position in Treasuries to fund the build out of these investments over time and so have avoided the liquidity problems facing other institutions.

So when the sub-prime crisis hit in February 2007, we were already in a relatively defensive position.

Still, we took additional measures at that time to batten down the hatches. We moved our cash into Treasuries and shut down our securities lending program. We worked with our hedge funds to ensure that they were on top of counterparty risk issues and that our assets were safely insulated from the problems that the investment banks and prime brokers were soon to face.

We were fortunate to recognize these risks relatively early and have so far avoided any calamitous mistakes that might have exposed the endowment to a permanent loss of capital. That's not to say that the endowment hasn't suffered losses. The decline in the equity markets over the past year has most definitely affected the performance of the endowment even if we didn't own sub-prime or weren't trapped in Lehman. We are significantly ahead of the S&P; 500, but we are still down. What next?

Although we are still deeply concerned about the potential for the financial crisis to spiral further, we are now starting to turn our attention to how we can take advantage of this dislocation. Every asset is seemingly for sale. High quality equities, bank loans and senior tranches of mortgage backed securities are all trading at a discount to fair value even after pricing in a long and painful recession.

Starting this spring, we began making commitments to a number of funds that specialize in distressed debt. These commitments are typically called over months, if not years, so we will have the advantage of having gotten invested as prices declined through the summer and fall and, most likely, into next year.

We funded these investments by reducing our public equity exposure. Although it was painful to do at the time, it has been a source of comfort in the months since. We sold at levels 50 percent higher than where equities are trading today. And, with roughly 15 percent of the portfolio still in Treasuries, we still have dry powder and look to get more aggressive in real estate and even private equity as distress works itself through these sectors.

It has been an extraordinary year, and the pace has been intense. My colleagues in the Office of Investments have worked tirelessly and often under great pressure to protect the endowment assets. Throughout we have had the full support of the administration and the wise counsel of the Investment Board. It's far from over, and we anticipate the next several years could be quite difficult as the damage works its way through the real economy.

We continue to test and retest our assumptions, combing through our portfolio to find opportunities to trade up from a good security to a great security and to identify any last remaining pockets of risk. And, we look forward to the time when the real risk is failing to have been aggressive enough. We are not quite there, but as investors we must remind ourselves that out of crisis often comes opportunity.

Kristin Gilbertson is the Chief Investment Officer of the University of Pennsylvania. 'Voices of the Administration' is a monthly series featuring Penn administrators.

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