Wednesday, June 20, 2018

Private Equity's Diversity Problem?

Sabrina Willmer of Bloomberg reports, TPG Scolded for ‘Stunning’ Lack of Diversity by Pension Official:
Jim Coulter, the billionaire co-founder of the giant private equity firm TPG, was in a Portland suburb with one of his largest clients when he got some tough questions.

The hot-button issue: a lack of diversity at the buyout firm.

The unexpected scene unfolded on June 6 at the Oregon Investment Council meeting -- and was recorded and posted on its website. The exchange offers a rare glimpse at how big investment firms are facing pressure from some institutional investors to change their white-male dominated culture.

About 30 minutes into the almost three-hour meeting, John Russell, the vice chairman of the council, asked the group to look at what amounted to Exhibit A: photos of the firm’s leaders in its flagship buyout unit, TPG Capital.

“When I first looked at that, it was stunning to me,” Russell said. A March TPG marketing document shows only 2 women among the 37 executives of TPG Capital. One of them is a partner.

“It isn’t that people of different ages, genders and ethnicity are better managers," Russell said to Coulter. "It is just that they have a view of the world that is broader. And companies can get into trouble without that diversity.”

Coulter responded that his firm needs to do better, particularly with women. “Our racial diversity is high relative to the industry,” he said at the meeting, referring to firm-wide numbers. “Our gender diversity with about 12 to 15 percent partners women is on average, but not nearly high enough in my view and it is something that we in the industry are working on."

Pension Pressure

Oregon isn’t the only state taking action following an onslaught of sexual harassment claims against executives in media, entertainment and finance.

The Los Angeles County Employees Retirement Association last year began asking private equity firms about their gender mix, sexual harassment claims and preventative measures, according to a person familiar with the matter. The Institutional Limited Partners Association, a trade group, plans to give questions to investors by September to use during due diligence about the gender and ethnic makeup by seniority of firms, policies promoting diversity and if anyone left due to sexual harassment.

"As awful as what these women went through in having to share their experience, it did provide a wake up call to the industry,” said Emily Mendell, who heads ILPA’s diversity effort. “Limited partners need to be part of the solution to harassment and diversity. Clearly this is a long-term game. Things are not going to change overnight.”

The private equity industry is run almost entirely by white men. Four of them -- Coulter, co-CEO Jon Winkelried, Chief Investment Officer Jonathan Coslet and co-founder David Bonderman -- lead TPG, according to the document viewed by Bloomberg. Women run or co-run other businesses, including a publicly-traded REIT, fundraising, compliance and capital markets at the firm, which manages $82 billion and is based in San Francisco and Fort Worth.

TPG, which has a diversity and inclusion committee headed by Winkelried, enhanced its health and family benefits for women and LGBTQ employees, and made recruiting more robust, the firm said in a statement. In the last two years, TPG has promoted five women to partner firm-wide, or 28 percent of the total.

Bonderman’s Remark

“The need for greater diversity and inclusion must be addressed throughout the financial industry. TPG is no exception,” said spokesperson Erika White. “We are proud of the progress we have made so far, but there is much more work to be done.”

At the June meeting with Coulter, Oregon’s Russell warned of the risks to companies that lack diversity, calling out Bonderman. Last year, amid the sexual-harassment controversy at Uber Technologies Inc., Bonderman made a sexist remark about female directors and then promptly resigned his board seat at the company.

“Your co-chair Bonderman was credited with part of the behavior that basically crippled the brand," said Russell, an office building owner in Portland with an MBA from Harvard. “And I would attribute that in part to lack of diversity.”

Coulter told the Oregon official that he was correct to raise the Uber incident.

“David made an undefendable comment,” he said. “He immediately apologized and immediately resigned from the board. I am pleased with how he responded in the aftermath even though I am embarrassed by the comment.”

Vote on TPG

Even as some institutional investors turn their focus to diversity, there’s no indication they will use money as leverage and withhold their backing of private equity funds. That could be costly. Buyout firms have been producing robust returns, helping them raise a record amount of capital last year.

After Coulter left the Oregon meeting, which covered TPG’s investment approach and market outlook, the council voted 4-1 to invest $500 million of the state’s pension plan in the firm’s buyout fund and health care pool.

The vote extended Oregon’s relationship with TPG, which goes back more than 20 years. In a statement to Bloomberg, John D. Skjervem, the chief investment officer of Oregon’s Treasury, applauded “TPG’s commitment to diversity and inclusion improvements.”

The no vote was cast by Russell. He said in an interview that while diversity was a concern, his dissenting vote was driven more by TPG’s wide-ranging investments.

Even though OIC sets the investment strategy for $102 billion in assets, including retirement savings, managed by the state treasury, Russell doesn’t think it has much influence when acting alone.

“The truth is, as big as Oregon is, we are just an asterisk in the whole scheme,” he said. “Until pension funds get together en masse, we won’t have much of an effect.”
Russell is right, the OIC can't change the industry alone which is why the Institutional Limited Partner Association (ILPA) is getting involved and sending out a questionnaire to its members to use in their due diligence with GPs.

The ILPA is wasting its time. For one, many of its members suffer diversity and inclusion problems within their own senior ranks.

I once attended an ILPA meeting in Chicago with Derek Murphy, PSP's former head of Private Equity. It was one big schmooze fest, a total waste of time in my opinion but I got to meet Mark Wiseman there and met some other big investors. Let me tell you, it was mostly white men attending this meeting and I include myself as part of that group.

Another reason why the ILPA wasting its time? Because private equity is run by old white men, most of which have a very high opinion of themselves and privately scoff at diversity and inclusion.

This article singles out TPG but trust me, it's not that much better at other big private equity funds. Go and drill down at their upper management and look at who's calling the shots, old white men.

"So what? What's wrong with that? David Bonderman, Jim Coulter, Henry Kravis, George Roberts, Stephen Schwartzman, Leon Black, David Rubentein, William Conway are all successsful private equity titans who worked hard to become billionaires and they can do whatever they want."

Well, not exactly. They became billionaire through the billions public pensions invested in their funds so they do have to answer to their investors just like public companies have to answer to them when it comes to diversity in upper management and at the board.

Why are pensions putting the pressure on private equity and public companies to focus on diversity and inclusion? It's not just a social mission, they're acting as fiduciaries who are first and foremost looking for better returns over the long run and it turns out diversity and inclusion are important factors for any organization to improve its long-term performance.

I personally hate the word "diversity". It's limp and impotent, offers no power. I much prefer inclusion and empowering women and minorities to make real consequential decisions.

By the way, some private equity funds are doing a lot better than others when it comes to diversity and inclusion so it isn't fair to bundle them all up but truth be told, the real power in the industry still resides with old white men.

And it's not just private equity. The hedge fund industry isn't any better, at least not at the very top. It too is run by old white men but there are cracks starting to test that male-dominated power structure.

Leslie Picker, Dawn Giel and Jen Zwebenof CNBC recently reported, The woman suing Point72 and Steve Cohen speaks out about alleged gender and pay discrimination:
Lauren Bonner says quitting wasn't an option.

Bonner is head of talent analytics at hedge fund Point72, a job that gives her access to data like compensation and college grade point averages for individuals hired by the firm. But as she tells it, that data unveiled a gross injustice — one that, inspired by the broader #MeToo movement, encouraged her to take action.

In February, Bonner filed a gender-bias lawsuit against Connecticut-based Point72, though she continues to go to work at the firm's Manhattan office every day.

"I certainly tried to make change internally," Bonner told CNBC in her first television interview. "I just couldn't let it go. I couldn't walk away from the problem. It's too important. It was too blatant, and it's been going on for way too long. I just couldn't help but fight it."

In her lawsuit, filed in New York federal court, Bonner accuses Point72, as well as its founder, the well-known hedge-fund manager Steven Cohen, and its now-former president Douglas Haynes of sexism. Bonner said they violated equal-pay laws, engaged in gender discrimination and retaliated against her by denying a promotion after she reported her superior for harassment.

In a statement to CNBC, Point72 said, "Contrary to Ms. Bonner's assertions, this lawsuit is replete with allegations that are false or based on unsubstantiated hearsay and that she never brought to the attention of Firm management."

Bonner continues to go to work at Point72, a situation she described as, "awkward but also not that bad." She said previously she would come to work "demoralized," but now she feels "a little bit more positive" about what she's doing.

Does Wall Street have an institutional bias?

Bonner's claim intertwines stories of harassment, data on pay disparity and a lack of diversity among the senior ranks at the firm, as well as the obstacles she faced in climbing the ladder.

She said that all of these issues are some form of discrimination against women.

"What I saw over time, looking through the data, was that there was an institutional bias that was so entrenched that it just made it pretty impossible for women to advance economically or professionally," she said.

In her claim, Bonner said that of the 125 portfolio managers that Point72 employs, all but one are men. She said there is only one woman among 32 managing directors. Bonner also points to last year's new hires, of whom, she said, only 21 percent were women; none was brought in as portfolio manager or managing director, she said. One new director was a woman, while 14 were men, she said.

"I see things like female candidates coming out of college have to have GPAs and SATs that are 20 percent to 25 percent higher than their male peers to get the exact same job," Bonner said in the interview.

"I absolutely believe it's due to an inherent bias against women," said Jeanne Christensen, a partner at Wigdor LLP, the law firm representing Bonner in her claim. "It just seems very suspect that you would have an extremely successful company with not one woman at the top."

In the claim, Bonner compared her own compensation with the pay of specific male colleagues. She had been seeking a promotion to the director level from associate director but was denied. She said she believes her inability to move up at Point72 (and narrow the pay gap) was because she reported one of the members of the promotion committee to human resources for alleged harassment. She said he retaliated against her by not granting her the title of director.

'Too aggressive' for a promotion

Bonner had only been at Point72 for about 18 months when she filed the lawsuit but said her short tenure was not a factor in the promotion committee's decision.

"It couldn't be experience because men with lesser and worse experience came in at a higher level than I did — off the bat," Bonner said. "It's also hard to imagine that it has anything to do with performance because I got the highest possible performance reviews."

Bonner said she was told she was "too aggressive to be promoted."

"You certainly don't build a cutting-edge technology platform by being a hothouse petunia, so I certainly had to be assertive to get things done," she said. "It's confusing to be labeled with that word, aggressive, when it's a culture of performance, and men are specifically told to be more aggressive and to break more china."

Bonner alleges that men with less experience and fewer responsibilities were coming into Point72 at the director level, which ranks above associate director. She said her compensation was as low as 35 cents on the dollar that these men made. Bonner says that she hasn't seen instances of women making more than men who were doing the same job at Point72.

"I don't think this is a question of nuance," she said.

A spokesperson for Point72 said the firm "was already addressing the underrepresentation of women and minorities — a reality across the finance industry — with a series of initiatives designed to recruit and support them before Ms. Bonner was hired. In fact, she was involved with some of those initiatives."

"But instead of working with us constructively to advance our goals of diversity and inclusion — and after only 18 months of employment at the Firm — Ms. Bonner demanded $13 million, and sued when that demand was rejected."

A representative for Bonner declined to comment on the $13 million figure.

An internal review of the firm's culture

Point72 is seeking to move the case from court to arbitration, where the merits of it would be argued out of the public eye. That decision is up to a judge, who has yet to rule on the firm's request.

Regardless of the forum, Bonner will find herself up against a defendant who is known for his dogged battles through the court system. Cohen's former hedge fund, SAC Capital, paid a record $1.8 billion fine to the government to settle charges of insider trading brought against the firm in 2013.

Cohen himself was charged in a civil case by the Securities and Exchange Commission with failure to supervise his employees and was banned from managing outside capital as part of a settlement. He did not admit or deny wrongdoing, and the ban was lifted earlier this year.

Also this year, Point72 hired the law firm WilmerHale to conduct an internal review into the firm's culture. Cohen announced several changes in April following the review, including expanded parental leave and the creation of "Chief Inclusion and Engagement Officer."

"We conducted an internal review for Point72 because Steve Cohen wanted to ensure that his firm was living up to its stated values," said WilmerHale's Jamie Gorelick, who led the review. "He fully embraced changes that we suggested in a way that is rare for a corporate leader. I think that the firm's culture is already stronger."

The firm has previously said that the review was not in response to Bonner's lawsuit. Haynes as well as Michael Butler, head of human resources, departed the firm between March and April. Haynes couldn't be reached for comment.

In an email to CNBC, Butler said he decided to retire after four years as Point72's head of human capital and will act as a consultant to the firm until the fall. "I am extremely proud of the transformational work we did with our Human Capital team during my tenure, finding new ways to source, select, develop, reward and retain our employees. We delivered on our Mission to create the greatest opportunities to the industry's brightest talent. "

Bonner said she doesn't know if the departures were a result of the suit, only to say "They left shortly after I filed."

"The real win I hope for is an intolerance of bad behavior at the firm," Bonner said. "And ultimately, of course, I hope for gender parity and equal pay."

When asked whether her job has changed at all since she filed the lawsuit, Bonner said, "My role is the same, but I'm a little less busy than I used to be."

Bonner, who has previously worked at the largest hedge fund in the world, Bridgewater Associates, conceded that sexism is an "industry-wide issue," but added that it's "particularly acute at Point72."

But so far no other women have publicly signed onto her lawsuit or filed a similar one against Point72. And few have come forward to call out any type of systematic bias on Wall Street.

"There's a reason more stories haven't come out, and it's not for lack of stories," Bonner said. "They haven't come out because of this culture of this small boys club that you really have to know other people to get jobs."

There are some other high profile gender bias cases on Wall Street. In March, a federal judge cleared the way for a class action lawsuit against Goldman Sachs. Four women who are former employees sued the bank in 2010 over allegations of systemic gender bias, including discrimination in pay and job promotion. Goldman has asked the court of appeals to review the decision.

As for what hedge funds and other financial institutions can and should be doing to make the environment better for women, Bonner said it's as simple as awareness by leadership.

"Choose to be intolerant of bad behavior," she said. "It may be uncomfortable to call someone out. But that's what actually changes a culture. And I would say for leaders at funds to actually embrace intolerance of poor behavior, would actually go a long way."
Now, I'm on record stating that it's time for investors to take a closer look at hedge funds and I wouldn't flinch investing in Steve Cohen's new fund (but I wouldn't pay 3 & 30 to him or anyone else).

But when I read Bonner's accusations, she raises several red flags. She might be after money but she might just be sick and tired of the "old boys club" and trying to do something about it.

I certainly don't buy the utter nonsense that she was "too aggressive for a promotion". The woman has cojones and she's proving it. Cohen would have definitely promoted her if she was a man. He knows it, she knows it and I know it.

Hell, the whole world knows it which is why my best advice to Steve Cohen is cut your losses, promote her and give her more responsibility at your firm. If it's a question of pride, swallow it, ten years from now, you won't care especially if it turns out to be the greatest decision of your life.

Having said this, I will defend Cohen and others on one point, these discrimination suits aren't always black and white. Sometimes you see women who bark loud being promoted and just like men who bark loud being promoted, they often don't deserve it.

There are a lot of men and some women in the finance industry who have a grossly inflated view of their qualifications and what they offer their employer.

To these men and women, all I have ot say is come into my universe where all you have is a computer and try to make a buck to survive by eating what you kill.

The market doesn't care if I'm short, tall, fat, skinny, good looking, ugly, a woman, a man, trans, gay, disabled or a visible minority, the market is equally ruthless to everyone, which is the one truism every investment manager knows all too well.

Every single day, I sit in front of my computer or iPad and just look at stocks and charts and the one thing I love is it's me versus Miss Market and let me tell you, she's ruthless and always looking to take my money. Sometimes she wins and sometimes I win, and as long as I can beat her most of the time, I'm surviving, but man does she suck out all my energy!!

On that note, here are the stocks making big moves on my watch list today (click on image):


Once again, don't try trading or investing in any of these stocks, especially if you don't know what you're doing, you might get whacked hard when you least expect it:


Below, Jason Kelly of Bloomberg News reports on TPG's diversity problem. Like I said, it's not just TPG although it looks to be lagging its peers when it comes to diversity and inclusion.

And Lauren Bonner, plaintiff in a lawsuit against Steve Cohen’s hedge fund, discusses her decision to take Point72 to court with CNBC’s Leslie Picker.

Is Mrs. Bonner right to sue? I don't know, all I know is she is courageous to take on one of the fiercest sharks in the hedge fund industry. Maybe Steve Cohen has finally met his match, but whatever happens in this case, it's time everyone in the private equity and hedge fund community and their big investors take note, diversity and inclusion are a real problem.


Tuesday, June 19, 2018

CalPERS Gears Up CalPERS Direct?

Arleen Jacobius of Pensions & Investments reports, CalPERS gears up for private equity portfolio changes:
Private equity was a big theme at CalPERS' investment committee meeting on Monday.

The $356.5 billion California Public Employees' Retirement System, Sacramento, adopted a new investment policy statement that includes lowering the benchmark return for its private equity portfolio. The committee also discussed a proposal to change its private equity investment structure that includes creating an outside corporation to make direct investments, and it reviewed the first draft of a new private equity investment policy.

Chief Investment Officer Theodore Eliopoulos kicked off the meeting by stressing the importance of private equity to the system's total portfolio.

Private equity has had the highest return of any asset class and that is expected to continue, Mr. Eliopoulos said. He said the private equity portfolio has added $11 billion over public equities. Private equity also expands the investible universe and has exhibited the most growth in the capital markets, he said.

"There's no obvious public markets substitute for the private equity portfolio," he said.

This is important because CalPERS is 71% funded and has an expected rate of return of 7%, which is "relatively high" and could be difficult to achieve, especially with a lower interest-rate environment, Mr. Eliopoulos said.

"Private equity is the only asset class projected to provide more than 7% return over the next 10 years," he said.

CalPERS' new investment policy for the entire plan lowers the private equity benchmark to FTSE Global All-Cap index plus 150 basis points, lagged by a quarter, from a custom benchmark of 67% FTSE U.S. Total Market index and 33% FTSE All-World ex-U.S. index plus 300 basis points, also lagged one quarter. The new policy also requires prudent person opinions by an outside firm for private equity co-investments and customized separate accounts.

During the discussion of its new private equity structure, Mr. Eliopoulos noted that CalPERS would have to commit about $10 billion to $13 billion a year to get to and maintain a 10% private equity allocation. Currently, the private equity target allocation is 8% plus or minus 4 percentage points, with a 7.7% actual allocation.

"This strategy reflects our conclusion that CalPERS needs to substantially add to our current business model and to our internal resources to achieve our objective of a substantial and successful private equity portfolio over time," he said.

The structure has four pillars: the partnership model; emerging managers; and two strategies that would be run by a separate corporation, CalPERS Direct — private equity and venture capital. CalPERS' investment staff will now begin researching industry best practices regarding the makeup of both the independent advisory boards for the private equity and venture capital direct investment strategies and the management teams for CalPERS Direct.

CalPERS executives would like to invest more capital in its emerging private equity manager fund-of-funds program and add co-investments with the managers, Mr. Eliopoulos said. CalPERS currently has $350 million in two private equity emerging manager funds-of-funds portfolios.

During the discussion on the new private equity structure, Ashby Monk, executive and research director at Stanford University's Global Projects Center, told the committee it was not the only asset owner considering establishing an "arms-length" entity to invest in private equity.

Investors are stuck with private equity, even if they don't like the alignment of interest or the fees, because it is likely to produce better returns than the public markets, Mr. Monk said.

"So, you need it but the challenge is that everybody else has realized they need it too," resulting in a flood of money into the asset class, Mr. Monk said. "We need to be innovative," he said.

A few committee members noted that time is of the essence and that CalPERS needed to create a new structure soon or it would be left behind.

"The fact that it's not going to get better where we are today ... we have a lot of choices in how we design this, how we construct it," said Bill Slaton, board member. "I don't think we have a lot of choice doing it. I think we'll be compelled by the marketplace to do it."

Mr. Monk agreed. "You're not alone," he said. "You guys are on a journey I can think of probably 20 or 25 plans like you right now are saying, 'how are we going to do this?'"

CalPERS' investment committee also had a first look at a new private equity investment policy proposal that removed direct investments in private equity firms as a transaction type. The current policy includes direct investments "including independently sourced investments." However, during the investment committee meeting, Sarah Corr, interim head of CalPERS' private equity program, explained that "direct investments" referred to investments in private equity general partnerships.

The only direct investments CalPERS has made in private equity are stakes in general partnerships, said Megan White, spokeswoman.

CalPERS invested in private equity firms only a few times on an opportunistic basis and hadn't taken a general partnership stake since 2007, she told the investment committee. In that year, CalPERS took minority stakes in Apollo Global Management and Silver Lake. CalPERS had also taken a minority stake Carlyle Group in 2001.

In an interview, Ms. Corr said the new private equity investment policy, if adopted, would remove the strategy as a simplification measure. The new policy also expresses staff's authority to make investments without board approval in dollar terms from percentage of the total private equity assets.

The policy would also remove the requirement that staff obtain board approval for private equity funds of managers that are not at least second quartile. However, CalPERS staff would need to obtain a prudent person opinion for commitments to funds of managers that are not at least second quartile.

The private equity policy would also lower staff's authority to make commitments to top-quartile investments without investment committee approval, while increasing that authority for second-quartile funds. The managing investment director authority to commit to top-quartile funds without investment committee approval would be reduced to $500 million from 4% of the private equity portfolio, and the CIO's limit would be reduced to $1 billion from 8%. But the managing investment director's authority to invest in second-quartile funds would be increased to $500 million from 0.75% of the portfolio and the CIO's authority would increase to $1 billion from 1.5%.

Impact investing

Separately, CalPERS staff and Pacific Community Ventures, a impact investing consultant, gave the final report for its $2.1 billion California private equity investment initiative, a program it has been winding down since 2013, Mr. Eliopoulos noted. The only portion of the program that will be kept are co-investments, which will be part of CalPERS' new private equity structure, he said. CalPERS is winding down the program to which it committed $1 billion since its 2001 inception in order to move "side programs" into the main private equity investment program.

The program which was established to invest private equity in traditionally underserved markets, primarily but not exclusively in California, and has been successful in investing in underserved markets and in women and minority-owned businesses, he said. CalPERS will support women- and minority-owned businesses as an ancillary benefit of its emerging manager program. Staff is studying whether investing in emerging managers also has an impact on investing in underserved areas, Mr. Eliopoulos said.

Board diversity

Also, the investment committee plans to enhance its definition of what it means to have a successful board diversity program so that staff can file shareholder proposals and vote against directors at U.S. companies that lack diversity. The so-called "key performance indicators" would change to require all public companies in which CalPERS invests have a level of board diversity that reflects each company's business, workforce, customer base and society in general. Currently, the key performance indicator showing success is that the companies in which CalPERS invests has "a dimension of board diversity."

"I think many of us on the board and staff are concerned about how long it's taking to improve board diversity, particularly in the U.S., when we see it could benefit performance," said Beth Richtman, managing investment director of the sustainable investment program.

At the July 16 off-site meeting, staff plans to provide a session on innovations in board diversity, including technology and new practices. In response to committee member questions, Simiso Nzima, investment director, global equity and head of corporate governance, told the committee that staff is talking to a number of institutional investors about mandatory diversity data disclosure, but that building coalitions of investors takes a long time.

"Our approach really is multipronged and we don't want to wait to build the coalition," Mr. Nzima told the committee. "We want to be able to start moving in that direction."
You can review the material from Monday's Investment Committee here.

I bring your attention to the update on private equity busines model alternatives where is specifically states:
Background

In relation to the announcement of CalPERS Direct, the new strategic model for private equity, this item focuses on the next steps regarding the implementation of this direct investment vehicle with independent board governance. After more than a year of planning and discussion, the Investment Office is ready to move into the next phase of development. CalPERS’ Investment Office staff will now begin its research into industry best practices regarding the makeup of both the independent advisory boards and the management teams.

Analysis

In order to leverage the strength of our portfolio and increase scalability and long–term sustainability, the proposed plan for CalPERS Direct involves the creation of two separate funds. The first would be focused on late-stage investment in technology, life sciences and healthcare, and the second on long-term investments in established companies. CalPERS Direct would be governed by a separate independent Board made up of members from subsidiary Boards and other independent Board members, to advise on allocation. The proposed timeline calls for CalPERS Direct to launch in the first half of 2019, following final approval by the Board.
Not surprisingly, Yves Smith of the naked capitalism blog jumped all over CalPERS Direct over the weekend, claiming a leaked memo by Larry Sonsini shows Sonsini and CalPERS are violating their fiduciary duty with the proposed private equity outsourcing scheme.

Yves ends her long diatribe with some very serious and wild accusations:
Last week, highly respected Sacramento columnist Dan Walters also wrote about the whiff of corruption coming from CalPERS’ private equity restructuring scheme. Even for those like Walters who don’t know much about private equity, there is too much that is obviously wrong here, from CalPERS not dropping or at least suspending its plans now that its cheerleader in chief is quitting, to CalPERS branding and too many other claims being obviously demonstrably false, to the scheme going firmly against the positive steps other large limited partners are taking, that of building staff skills and bringing more deal-makgin and management in house.

The only two explanations are utter incompetence or rank corruption in the form of Ted Eliopoulos trying to curry favor with BlackRock and other influential players in order to bolster his future employment prospects. And before allies of Eliopoulos in and outside CalPERS act outraged, this suspicion is widespread among the journalists and limited partner community. You are only shooting the messenger.

The more and more CalPERS sticks to this plan in the face of deservedly critical press, the more it looks like dirty dealing. And with CEO Marcie Frost having amassed decision-making authority in her office, she will have nowhere to hide if this scheme blows up on her watch, as we fully expect it will.
So, Ted Eliopoulos is trying to buy himself a cushy job at BlackRock by moving ahead with CalPERS Direct?

God damn Greeks! They're all crooked little weasels! God forbid Ted Eliopoulos put this idea forward because it actually makes sense for CalPERS and its stakeholders over the run.

And those BlackRock guys! They too are little weasels in the eyes of Yves Smith and her followers who think she's an authority on private equity (quite the opposite). The nerve of Larry Fink going out to recruit Mark Wiseman from CPPIB, André Bourbonnais from PSP and a couple of Goldman stars to beef up this PE group. Who does he think he is, Warren Buffett? How dare he ask CalPERS to outsource part of its PE program to BlackRock?

First of all, it's not a done deal yet (as far as I'm aware). BlackRock is competing with a few big players like Neuberger Berman Group and others. The key here is "big" players which will help ramp up direct investments (co-investments) at CalPERS relatively quickly.

You need experienced players who know what they're doing to ramp up CalPERS Direct. And you need an independent board to move things along quickly and diligently. There is no fraud going on here, just good old fashion hard work to ramp up CalPERS Direct.

Why CalPERS Direct? Look at the success of Canada's large pensions in ramping up direct investing (co-investments) with their private equity general partners. Co-investments are a form of direct investing where general partners (GPs or funds) approach their limited partners (LPs or investors) to invest alongside them on larger transactions.

In order to gain access to co-investments, LPs first have to invest in private equity funds but once they do that, they can ramp up co-investments to lower overall fees (pay no fees on co-investments). This can only be done if pensions have an experienced private equity team to quickly evaluate co-investment opportunities as they arise.

I recently spoke about how PSP Investments is ramping up direct private equity. The Caisse's private equity group led by Stephane Etroy is also going direct in PE.

Ontario Teachers' started this trend years ago under the watch of Jim Leech who hired Mark Wiseman to ramp up the fund and co-investment portfolio. Mark took that experience over to CPPIB where he did the same thing with the help of André Bourbonnais.

"It's a big club and you ain't in it. You and I aren't part of the big club," as George Carlin once noted in his famous American Dream skit.

Nope, people like Mark Wiseman and André Bourbonnais are operating on another level and they're now part of the big club. By the way, so is André Collin who arguably did buy his position at Lone Star and then worked hard to convince John Grayken to make him president of his fund.

Collin is part of the big club and now enjoys compensation that makes his old PSP bonuses look like chump change.

Good for him, good for all these guys, but there's something you need to remember, you don't get invited to the big club because of your good looks and once you're in, you need to produce results or you'll find yourself out of a job fairly quickly.

It's easy sitting in a nice chair at CPPIB or PSP, ordering people around, much tougher when a John Grayken or Larry Fink are on your ass constantly to produce results. In short, the big club has big paydays but it's brutal work.

I mention this because unlike Yves Smith, I actually think it makes a lot of sense for CalPERS to outsource part of its PE program to BlackRock because Mark Wiseman, André Bourbonnais and others in that group have great experience and can help CalPERS ramp up their co-investments quickly and efficiently.

Moreover, I know for a fact that tight governance rules forbid any investment staff at CalPERS to join a fund they invest in for a period of three years after the initial investment takes place (there were no such rules at PSP when Collin collected his million dollar bonus and then hopped over to join Grayken at Lone Star where he now runs the fund).

Ted Eliopoulos is just doing his job and he already signalled he's stepping down for family reasons.

More importantly, what if Yves Smith is wrong and CalPERS Direct turns out to be a great success over the next ten years, not a "bomb"? Is she going to praise Eliopoulos then? I highly doubt it.

As far as the PE benchmark at CalPERS being changed to FTSE Global All-Cap index plus 150 basis points, lagged by a quarter, from a custom benchmark of 67% FTSE U.S. Total Market index and 33% FTSE All-World ex-U.S. index plus 300 basis points, I'm not surprised.

Go read a recent comment of mine on private equity going public where I note the following:
Clearly, these are good times for private equity titans. They are raising multibillions for their megafunds and most of that money is coming from global pensions and sovereign wealth funds.

Given the amount of money pouring into private equity, it's not surprising to see PE giants increasingly focused on taking public companies private. And there is no doubt that private companies have better alignment of interests with their shareholders who typically focus on long-term added value.

But increasingly playing in public markets raises concerns too. In particular, as Javier Espinoza of the Financial Times reports, Valuations for private and public companies are narrowing:

Valuations for private and public companies are narrowing, data by the Boston Consulting Group show, prompting concerns that investors could be overpaying for privately held assets (click on image).


The narrowing of the gap has been driven partly by private equity investors paying record multiples for assets as they come under pressure to deploy capital, according to industry analysts.

This could eventually lead to investors finding better value and more liquidity in publicly traded companies if economic conditions were to change dramatically, these observers warned.

“Buyout funds have historically valued private companies based on their historical averages,” said the private equity head of a multibillion fund in London. “But private equity investors have raised a lot of capital and to get deals done they are having to pay full price. Many are starting to ignore their traditional metrics.”

The person added: “It’s like 2006 and 2007 all over again.”

Yield-starved investors have been under growing pressure to deploy their capital in a low-interest rates environment. As a result, demand for private equity has risen in recent years, which in return has led buyers to pay record multiples for assets.

In 2017, investors paid on average 12.5 times multiples for private companies compared with 9.5 times multiples a year earlier. This compares with 16.8 times multiples paid for public companies last year versus 19.5 times multiples a year earlier, the data showed.

Industry observers also said that a narrowing of the gap would lead some to reassess their exposure to private equity. “If you want to re-calibrate your portfolio, you can take instant action in the public markets. While you can’t with private equity exposures. You can try and sell your stake in the secondary market but at huge discounts.”

However, Antoon Schneider, senior partner and managing director at the BCG, said that investors were still paying less on average for private companies than for listed companies.

“Private equity investors are not paying more than if they bought shares in the stock exchange and they hopefully get superior governance and better returns,” he said. “The private equity boom is still less than the stock market overall.”
Again, it's confusing but as private equity funds get bigger and bigger, they are forced to take public companies private in order to deploy the capital, so I'm not shocked to see valuations are narrowing between public and private companies.
All this to say a spread of 300 basis points might be too tough to beat in this environment (I remember when pension funds were using a spread of 500 basis points but those days are long gone as money pours into private equity).

Anyway, those are my thoughts on CalPERS gearing up for changes to its private equity portfolio. The most important thing to note is private equity remains the most important asset class at CalPERS and if they can bring on experienced people to help run CalPERS Direct, they will also enjoy a well-run co-investment portfolio which helps them scale up quickly and lower overall fees.

That's it, that's all, there is nothing remotely shady going on here.

Below, I embedded CalPERS's Investment Committee meeting from May 14th. Take the time to watch this clip and if they post the one from Monday's meeting, I will edit this comment and add it.

Monday, June 18, 2018

The Great Pension Train Wreck?

John Mauldin wrote a comment recently that caught my attention, The Pension Train Has No Seat Belts:
In describing various economic train wrecks these last few weeks, I may have given the wrong impression about trains. I love riding the train on the East Coast or in Europe. They’re usually a safe and efficient way to travel. And I can sit and read and work, plus not deal with airport security. But in this series, I’m concerned about economic train wrecks, of which I foresee many coming before The Big One which I call The Great Reset, where all the debt, all over the world, will have to be “rationalized.” That probably won’t happen until the middle or end of the next decade. We have some time to plan, which is good because it’s all but inevitable now, without massive political will. And I don’t see that anywhere.

Unlike actual trains, we as individuals don’t have the option of choosing a different economy. We’re stuck with the one we have, and it’s barreling forward in a decidedly unsafe manner, on tracks designed and built a century ago. Today, we’ll review yet another way this train will probably veer off the tracks as we discuss the numerous public pension defaults I think are coming.

Last week, I described the massive global debt problem. As you read on, remember promises are a kind of debt, too. Public worker pension plans are massive promises. They don’t always show up on the state and local balance sheets correctly (or directly!), but they have a similar effect. Governments worldwide promised to pay certain workers certain benefits at certain times. That is debt, for all practical purposes.

If it’s debt, who are the lenders? The workers. They extended “credit” with their labor. The agreed-upon pension benefits are the interest they rightly expect to receive for lending years of their lives. Some were perhaps unwise loans (particularly from the taxpayers’ perspective), but they’re not illegitimate. As with any other debt, the borrower is obligated to pay. What if the borrower simply can’t repay? Then the choices narrow to default and bankruptcy.

Today’s letter is chapter 6 in my Train Wreck series. If you’re just joining us, here are links to help you catch up.
As you will see below, the pension crisis alone has catastrophic potential damage, let alone all the other debt problems we’re discussing in this series. You are sadly mistaken if you think it will end in anything other than a train wreck. The only questions are how serious the damage will be, and who will pick up the bill.

Demographics and Destiny

It’s been a busy news year, but one under-the-radar story was a wave of public school teacher strikes around the US. It started in West Virginia and spread to Kentucky, Oklahoma, Arizona, and elsewhere. Pensions have been an issue in all of them.

An interesting aspect of this is that many younger teachers, who are a long way from retirement age, are very engaged in preserving their long-term futures. This disproves the belief that Millennial-generation Americans think only of the present. From one perspective, it’s nice to see, but they are unfortunately right to worry. Demographic and economic reality says they won’t get anything like the benefits they see current retirees receiving. And it’s not just teachers. The same is true for police, firefighters, and all other public-sector workers.

Thinking through this challenge, I’m struck by how many of our economic problems result from the steady aging of the world’s population. We are right now living through a combination unprecedented in human history.
  • Birth rates have plunged to near or below replacement level, and
  • Average life spans have increased to 80 and beyond.
Neither of these happened naturally. The first followed improvements in artificial birth control, and the second came from better nutrition and health care. Each is beneficial in its own way, but together they have serious consequences.

This happened quickly, as historic changes go. Here is the US fertility rate going back to 1960.


As you can see, in just 16 years (1960–1976), fertility in the US dropped from 3.65 births per woman to only 1.76. It’s gone sideways since then. This appears to be a permanent change. It’s even more pronounced in some other countries, but no one has figured out a way to reverse it.

Again, I’m not saying this is bad. I’m happy young women were freed to have careers if they wished. I’m also aware (though I disagree) that some think the planet has too many people anyway. If that’s your worry, then congratulations, because new-human production is set to fall pretty much everywhere, although at varying rates.

Breaking down the US population by age, here’s how it looked in 2015.


Think of this as a python swallowing a pig. Those wider bars in the 50–54 and 55–59 zones are Baby Boomers who are moving upward and not dying as early as previous generations did. Meanwhile, birth rates remain low, so as time progresses, the top of the pyramid will get wider and the bottom narrower. (You can watch a good animation of the process here.)


This is the base challenge: How can a shrinking group of working-age people support a growing number of retirement-age people? The easy and quick illustration to this question is to talk about the number of workers supporting each Social Security recipient. In 1940, it was 160. By 1950 it was 16.5. By 1960 it was 5.1. I think you can see a trend here. As the chart below shows, it will be 2.3 by 2030.


Similarly, states and local governments are asking current young workers to support those already in the pension system. The math is the same, though numbers vary from area to area. How can one worker support two or three retirees while still working and trying to raise a family with mortgage payments, food, healthcare, etc.? Obviously, they can’t, at least not forever. But no one wants to admit that, so we just ignore reality. We keep thinking that at some point in the future, taxpayers will pick up the difference. And nowhere is it more evident than in public pensions.

In a future letter, I will present some good news to go with this bad news. Several new studies will clearly demonstrate new treatments to significantly extend the health span of those currently over age 50 by an additional 10 or 15 years, and the same or more for future generations. It’s not yet the fountain of youth, but maybe the fountain of middle-age. (Right now, middle-age sounds pretty good to me.)

But wait, those who get longer lifespans will still get Social Security and pensions. That data isn’t in the unfunded projections we will discuss in a moment. So, whatever I say here will be significantly worse in five years.

Let me tell you, that’s a high order problem. Do you think I want to volunteer to die so that Social Security can be properly funded? Are we in a Soylent Green world? This will be a very serious question by the middle of the next decade.

Triple Threat

We have discussed the pension problem before in this letter—at least a half-dozen times. Most recently, I issued a rather dire Pension Storm Warning last September. I said in that letter that I expect more cities to go bankrupt, as Detroit did, not because they want to, but because they have no choice. You can’t get blood from a rock, which is what will be left after the top taxpayers move away and those who stay vote to not raise taxes.

This means city and school district retirees will take major haircuts on expected pension benefits. The citizens that vote not to pay the committed debt will be fed up with paying more taxes because they will be at the end of their tax rope. I am not arguing that is fair, but it is already happening and will happen more.

Let me say this again because it’s critical. The federal government can (but shouldn’t) run perpetual deficits because it controls the currency. It also has a mostly captive tax base. People can migrate within the US, but escaping the IRS completely is a lot harder (another letter for another day). States don’t have those two advantages. They have tighter credit limits and their taxpayers can freely move to other states.

Many elected officials and civil servants seem not to grasp those differences. They want something that can’t be done, except in Washington, DC. I think this has probably meant slower response by those who might be able to help. No one wants to admit they screwed up.

In theory, state pensions are stand-alone entities that collect contributions, invest them for growth, and then disburse benefits. Very simple. But in many places, all three of those components aren’t working.
  • Employers (governments) and/or workers haven’t contributed enough.
  • Investment returns have badly lagged the assumed levels.
  • Expenses are more than expected because they were often set too high in the first place, and workers lived longer.
Any real solution will have to solve all three challenges—difficult even if the political will exists. A few states are making tough choices, but most are not. This is not going to end well for taxpayers or retirees in those places.

Worse, it isn’t just a long-term problem. Some public pension systems will be in deep trouble when the next recession hits, which I think will happen in the next two years at most. Almost everyone involved is in deep denial about this. They think a miracle will save them, apparently. I don’t rule out anything, but I think bankruptcy and/or default is the more likely outcome in many cases.

Assumed Disaster

The good news is we’re starting to get data that might shake people out of their denial. A new Harvard study funded by Pew Charitable Trusts uses “stress test” analysis, similar to what the Federal Reserve does for large banks, to see how plans in ten selected states would behave in adverse conditions (hat tip to Eugene Berman of Cox Partners for showing me this study).

The Harvard scholars looked at two economic scenarios, neither of which is as stressful as I expect the next downturn to be. But relative to what pension trustees and legislators assume now, they’re devastating.

Scenario 1 assumes fixed 5% investment returns for the next 30 years. Most plans now assume returns between 7% and 8%, so this is at least two percentage points lower. Over three decades, that makes a drastic difference.

States are a larger and different problem because, under our federal system, they can’t go bankrupt. Lenders perversely see this as positive because it removes one potential default avenue. They forget that a state’s credit is only as good as its tax base, and the tax base is mobile.

Scenario 2 assumes an “asset shock” involving a 20% loss in year one, followed by a three-year recovery and then a 5% equity return for years five through year 30. So, no more recessions for the following 25 years. Exactly what fantasy world are we in?

Their models also include two plan funding assumptions. In the first, they assume states will offset market losses with higher funding. (Fat chance of that in most places. Seriously, where are Illinois, Kentucky, or others going to get the money?). The second assumes legislatures will limit contribution increases so they don’t have to cut other spending.

Admittedly, these models are just that—models. Like central banks models, they don’t capture every possible factor and can be completely wrong. They are somewhat useful because they at least show policymakers something besides fairytales and unicorns. Whether they really help or not remains to be seen.

Crunching the numbers, the Pew study found the New Jersey and Kentucky state pension systems have the highest insolvency risk. Both were fully-funded as recently as the year 2000 but are now at only 31% of where they should be.


Other states in shaky conditions include Illinois, Connecticut, Colorado, Hawaii, Pennsylvania, Minnesota, Rhode Island, and South Carolina. If you are a current or retired employee of one of those states, I highly suggest you have a backup retirement plan. If you aren’t a state worker but simply live in one of those states, plan on higher taxes in the next decade.

But that’s not all. Even if you are in one of the (few) states with stable pension plans, you’re still a federal taxpayer, and that’s who I think will end up bearing much of this debt. And as noted above, it is debt. The Pew study describes it as such in this chart showing state and local pension debt as a share of GDP.

For a few halcyon years in the late 1990s, pension debt was negative, with many plans overfunded. The early-2000s recession killed that happy situation. Then the Great Recession nailed the coffin shut. Now it is above 8% of GDP and has barely started to recover from the big 2008 jump.

Again, this is only state and local worker pensions. It doesn’t include federal or military retirees, or Social Security, or private sector pensions and 401Ks, and certainly not the millions of Americans with no retirement savings at all. All these people think someone owes them something. In many cases, they’re right. But what happens when the assets aren’t there?

The stock market boom helped everyone, right? Nope. States' pension funds have nearly $4 trillion of stock investments, but somehow haven't benefited from soaring stock prices.

A new report by the American Legislative Exchange Council (ALEC) shows why this is true. It notes that the unfunded liabilities of state and local pension plans jumped $433 billion in the last year to more than $6 trillion. That is nearly $50,000 for every household in America. The ALEC report is far more alarming than the report from Harvard. They believe that the underfunding is more than 67%.

There are several problems with this. First, there simply isn’t $6 trillion in any budget to properly fund state and local government pensions. Maybe a few can do it, but certainly not in the aggregate.

Second, we all know about the miracle of compound interest. But in this case, that miracle is a curse. When you compute unfunded liabilities, you assume a rate of return on the current assets, then come back to a net present value, so to speak, of how much it takes to properly fund the pension.

Any underfunded amount that isn’t immediately filled will begin to compound. By that I mean, if you assume a 6% discount rate (significantly less than most pensions assume), then the underfunded amount will rise 6% a year.

This means in six years, without the $6 trillion being somehow restored (magic beans?), pension underfunding will be at $8.4 trillion or thereabouts, even if nothing else goes wrong.

That gap can narrow if states and local governments (plus workers) begin contributing more, but it stretches credulity to say it can get fixed without some pain, either for beneficiaries or taxpayers or both.

I noted last week in Debt Clock Ticking that the total US debt-to-GDP ratio is now well over 300%. That’s government, corporate, financial, and household debt combined. What’s another 8% or 10%? In one sense, not much, but it aggravates the problem.

If you take the almost $22 trillion of federal debt, well over $3 trillion of state and local debt, and add in the $6 trillion debt of underfunded pensions, you find that the US governments from the top to bottom owe over $30 trillion, which is well over 150% of GDP. Technically, we have blown right past the Italian debt bubble. And that’s not even including unfunded Social Security and healthcare benefits, which some estimates have well over $100 trillion. Where is all that going to come from?

Connecticut, the state with the highest per-capita wealth, is only 51.9% funded according to the Wall Street Journal. The ALEC study mentioned above would rate it much worse. Your level of underfunding all depends on what you think your future returns will be, and almost none of the projections assume recessions.

The level of underfunding will rise dramatically during the next recession. Total US government debt from top to bottom will be more than $40 trillion only a few years after the start of the next recession. Again, not including unfunded liabilities.

I wrote last year that state and local pensions are The Crisis We Can’t Muddle Through. That’s still what I think. I’m glad officials are starting to wake up to the problem they and their predecessors created. There are things they can do to help, but I think we are beyond the point where we can solve this without serious pain on many innocent people. Like the doctor says before he cuts you, “This is going to hurt.”

We’ll stop there for now. Let me end by noting this is not simply a US problem. Most developed countries have their own pension crises, particularly the southern Eurozone tier like Italy and Greece. We’ll look deeper at those next week.

This is not going to be the end of the world. We’ll figure out ways to get through it as a culture and a country. The rest of the world will, too, but it may not be much fun. Just ask Greece.
Ah Greece, once land of great philosophers, heroes and warriors, now reduced to the land of pension haircuts and economic lost decades.

John Mauldin has done it again, writing a comment on pensions where he at once informs and misinforms us.

First, let me begin by where I agree with John. Public pension liabilities are debts we owe to people who are looking to retire with a safe, secure defined-benefit pension.

John is absolutely right that total US debt ($22 trillion) does NOT include state and local debt ($3 trillion) which doesn't include the $6 trillion in unfunded pension liabilities.

How does that old saying go, "a trillion here, a trillion there, pretty soon we're talking real money!".

And as I keep warning my readers, the pension crisis made up of unfunded public pension liabilities and lack of private savings in 401(k) type of plans, is deflationary.

In fact, excessive debt is deflationary as it detracts from future economic growth.

Add to this the aging of societies and you have the perfect cocktail for a long-term pension crisis.

The Montreal Gazette recently discussed a PwC study which claims the aging population is hurting Quebec's economy. Well, guess what? Other provinces and states aren't faring any better.

Remember the seven structural factors that lead me to believe we are headed for a prolonged period of debt deflation:
  1. The global jobs crisis: High structural unemployment, especially youth unemployment, and less and less good paying jobs with benefits.
  2. Demographic time bomb: A rapidly aging population means a lot more older people with little savings spending less.
  3. The global pension crisis: As more and more people retire in poverty, they will spend less to stimulate economic activity. Moreover, the shift out of defined-benefit plans to defined-contribution plans is exacerbating pension poverty and is deflationary. Read more about this in my comments on the $400 trillion pension time bomb and the pension storm cometh. Any way you slice it, the global pension crisis is deflationary and bond friendly.
  4. Excessive private and public debt: Rising government and consumer debt levels are constraining public finances and consumer spending.
  5. Rising inequality: Hedge fund gurus cannot appreciate this because they live in an alternate universe, but widespread and rising inequality is deflationary as it constrains aggregate demand. The pension crisis will exacerbate inequality and keep a lid on inflationary pressures for a very long time.
  6. Globalization: Capital is free to move around the world in search of better opportunties but labor isn't. Offshoring manufacturing and service sector jobs to countries with lower wages increases corporate profits but exacerbates inequality.
  7. Technological shifts: Think about Amazon, Uber, Priceline, AI, robotics, and other technological shifts that lower prices and destroy more jobs than they create. One study found that 800 million people might be out of a job by 2030 because of automation.
These are the seven structural factors I keep referring to when I warn investors to temper their growth forecasts and to prepare for global deflation.

This is why I'm definitely not in the inflation camp and think rising rates are being capped by these structural forces which shouldn't be confused with cyclical swings in inflation due to a depreciating currency.

Anyway, the point is John is right to worry about the pension train wreck but he also misses a great opportunity to talk to you about things that can help sustain public pensions over the long run.

Importantly, unlike John, I do not see this as a hopeless situation. Why? Because sooner or later the US and rest of the world (minus Denmark and the Netherlands) are all going to adopt two critical factors that have led to the long-term success of Canada's mighty pension plans:
  1. Adopt world-class governance which separates public pensions from governments completely, have them overseen by an independent and qualified board and managed by industry experts who are paid to deliver long-term excess returns investing across public and private markets all over the world. Most of this can be done internally, saving a bundle on fees.
  2. Adopt a shared risk model which ensures intergenerational equity and shares the risk properly between active and retired members. This way, when pensions run into trouble, it's not just active members paying more in contributions but also retired members that receive less benefits (typically, a small adjustment in their cost-of-living adjustment, they'll go a brief period without full inflation portection until the plan's funded status is fully restored).
Go read my recent comment on why OMERS is reviewing its indexing policy which is the right thing to do, making its plan young again like OTPP is doing.

There's no secret sauce to pension solvency. Asset returns alone cannot bring a plan back to fully funded status, not in a low growth, low rate, low return world. You need to adopt conditional inflation protection too or else you'll be swimming against the current.

But in the US, state and local governments aren't interested in world class governance or shared risk models. The ones suffering from chronic pension deficits are kicking the can down the road, something I discussed last week in my comment on why CPPIB is issuing green bonds:
Why is CPPIB issuing green bonds? It has over $356 billion under management and doesn't need the money so why is it issuing green bonds?

Cynics will claim it's just a green gimmick, another case of Canadian pensions cranking up the leverage to boost their returns and executive compensation.

Now, let's all take a deep breath in and out. I'll explain to you exactly why CPPIB wisely chose to issue green bonds.

First, it has nothing to do with leverage. CPPIB will invest $3 billion out of a total $356 billion so leverage isn't the reason behind issuing green bonds.

Second, it has everything to do with efficient use of capital. When a corporation issues a bond, it uses that money to buy back shares, invest in capital equipment or make a strategic acquisition, among other things.

When a pension issues a bond, any bond, it incurs liabilities and needs to invest that money wisely to earn a higher rate of return.

In the US, rating agencies are targeting underfunded public pensions and many of these state and local governments with chronically underfunded pensions are responding by kicking the can down the road, issuing pension bonds to invest and try to make up their shortfall.

It works like this. US state or local governments emit $100 million in pension obligation bonds, pay out 4.5% (assuming rates don't rise a lot) to investors and their public pensions use the proceeds to invest in stocks, corporate bonds, private equity funds and hedge funds to try to earn more than than that 4.5% being paid out (typically targeting a 7.5 or 8% bogey) to try to close the gap between assets and liabilities to improve its funded status.

And because a lot of the US state and local governments emitting pension obligation bonds are fiscally weak, their credit rating isn't very good so they need to pay an extra premium to investors to entice them to buy these pension bonds.

It's nuts when you think about it because they're taking credit risk (their own balance sheet can significantly deteriorate) and market risk (if interest rates rise or assets get clobbered), hoping they will invest wisely to earn more than what they're paying out to bondholders. This is why experts warn to beware of pension obligation bonds.

Are you with me so far? Great, because unlike US public pensions, Canada's large public pensions operate at arm's length from the government, enjoy a AAA credit rating because they're fully funded or close to it, they have world class governance, and are very transparent.

Their strong balance sheet and exceptional long-term track record allows them to emit bonds, any bonds, at a competitive rate as they receive a AAA rating, and then they can use those proceeds to target global investments across public and private assets all over the world.

So, issuing green bonds is nothing new, it's something old that only targets green investments, but the media reports make it sound like CPPIB is doing something way out of the ordinary.

It isn't. It's doing what it has done all along, what all of Canada's large pensions are doing, using their great balance sheet and long-term track record to emit bonds as rates are still at historic lows and use those proceeds to invest across global public and private markets to earn a better rate of return.

And they're not jacking up the leverage, at least CPPIB isn't relative to its overall portfolio. It simply boils down to efficient use of capital. That's it, that's all.
The pension obligation bond scam is going to come crashing down when the next financial crisis hits.

When will that be? That's the multi-trillion question but like John, I worry that the next "Big One" will be a lot rougher and last a lot longer.

Right now, it's steady as she goes, everyone keeps buying those FAANG stocks. I was listening to CNBC earlier today that Netflix (NFLX) is up almost 100% year-to-date and some analyst was saying it's going much, much higher and the same thing goes for Amazon (AMZN):



"Son, those are mighty bullish charts there, don't fight the trend, do what all the big hedge funds are doing and buy more of them FAANG stocks!"

Have you ever seen the movie "The Untouchables" where Robert De Niro plays mob boss Al Capone and takes out a baseball bat as he discusses "teamwork" with his lieutenants?



It's a gruesome scene but sometimes I think a lot of portfolio managers laughing it up, buying these FAANG stocks, playing momentum are going to get whacked so hard when they least expect it, it's going to clobber them and their unsuspecting investors.

But as we all know, markets can stay irrational longer than you can stay solvent, so keep dancing as long as the music is playing, just make sure you're hedging accordingly and taking money off the table when your positions run up a lot.

As far as the great pension train wreck, nothing to worry about yet, however, the sooner people realize the current course of action in the US isn't sustainable and they need to adopt elements of Canadian success (world class governance, shared risk model), the better off the US will be.

One thing I can tell you, beware of pension obligation bonds, they're bad for your fiscal and financial health. While CPPIB issues green bonds, US state and local governments are issuing more pension bonds. Watch Thad Calabrese, NYU, and Kuyler Crocker, Tulare County Board of Supervisors, discuss why cities are investing in the market through the issuance of pension bonds.

And don't believe all the bad news on US Social Security. Former Social Security Commissioner Mike Astrue discusses reports that Social Security is dipping into its reserves for the first time since 1982. Great discussion, he addresses many myths and alludes to the success of other countries "privatizing" their Social Security but doesn't talk about the success of the Canada Pension Plan.

Bottom line: The great pension train wreck is headed our way but the situation isn't as dire as John Mauldin and others make it out to be, at least not yet (that can easily change if a crisis whacks us).


Friday, June 15, 2018

Who's to Blame For Bumpy Markets?

Jeff Cox of CNBC reports, Trump's contradictions are swinging the stock market this year:
Looking for a reason why the market's been so bumpy this year? Blame Trump. Looking for a reason why the market has held up so well this year? Blame Trump.

There's been a overriding paradox this year for investors: President Donald Trump has been both a blessing and a curse, goosing stocks through tax cuts and vexing the market with a seemingly endless stream of gut-churning headlines.

"We don't recall a President who has been simultaneously so bullish and bearish for stocks," Ed Yardeni, head of Yardeni Research, told clients in a note earlier this week. "That might explain why the S&P 500 has been zigging and zagging since the start of this year."

Actually, the market's done pretty well for itself lately.

After a wickedly volatile first quarter that saw major averages foray into correction territory, stocks have bounced back nicely. The S&P 500 is now up 4 percent for the year, thanks to a nearly 8 percent jump since early April, and the Dow industrials have posted a 1.8 percent increase.


Tech stocks continue to lead the market, with the Nasdaq surging 12.4 percent.

Yardeni, an economist and market strategist, said actions and policies specific to Trump can be tied to the market's ups and downs. He cited a J.P. Morgan report that looked at market behavior and determined that tariff threats by the administration had held stocks back by 4.5 percent since March, resulting in a $1.25 trillion slice in market cap.

"I guess we can blame Trump for that loss thanks to his protectionist saber-rattling. On the other hand, he deserves credit for enacting a HUGE corporate tax cut at the end of last year," Yardeni wrote.

Republicans pushed the largest tax cut in U.S. history through Congress in December, a $1.5 trillion reduction that Yardeni said lowered taxes by 36 percent for nonfinancial corporations in the first quarter.

"We think the market is telling us that the signal is earnings that have been supercharged by the tax cut, while the noise is protectionist saber-rattling," he added. "That's been great for cyclical and growth stocks."

In fact, Yardeni said the Federal Reserve and its interest rate hikes have rattled the market more than Trump.

The central bank enacted its second interest rate increase of 2018 on Wednesday and indicated that two more quarter-point increases are on the way before the end of the year. In addition, the Fed is tightening monetary policy further through the reduction in bond holdings on its balance sheet.

However, the market looked to be headed for a loss Friday after Trump announced tariffs on Chinese technology imports that would amount to about $50 billion.

Overall, though, Trump has fared better than most of his predecessors at this point in his term.

Earlier this month, he observed his 500th day in office with the best Dow performance of any president since George H.W. Bush in 1989-90, and sixth-best among the 20 presidents since the turn of the 20th century, according to LPL Research.

Investors remain skittish, though, and have pulled $60.3 billion out of funds that focus on U.S. stocks, according to Investment Company Institute data through April.
Love him or hate him, President Trump has been very busy lately warming up to North Korea's leader as he rebuffs his G7 allies and he was back at it on Friday, slapping 25% tariffs on up to $50 billion of Chinese goods.

So what gives? I must admit, people don't understand Trump but as far as I'm concerned, he's as transparent as you can get.

First, he passed the largest tax cut in US history which mostly benefitted large corporations. That's the number one reason why the stock market keeps rising and that's why even though corporate America hates any prospect of a trade war, CEOs are not publicly criticizing Trump's administration.

Second, his protectionist saber-rattling is just feeding his base, working-class Americans who lost or are scared of losing their well-paid manufacturing jobs. We can argue whether these policies are doing more harm than good, but for Trump, it's all about optics and garnering votes.

In early April, I wrote a comment on whether trade wars will crash the market and I said "no". I still think trade wars are being blown way out proportion and while it's possible they escalate and have a material impact on the global economy, I still believe cooler heads will prevail before we reach the point of no return.

However, that's where my good news ends.

The problem right now isn't Trump or trade wars, the problem is the Fed hiking rates and signaling it will continue hiking rates.

People get all emotional on Trump but they're missing the bigger picture, the global economy is slowing and there's not a damn thing Trump can do about it. He's running out of fiscal bullets.

Have a look at the chart below, courtesy of Denis Ouellet's Edge and Odds blog, a great blog to track even if I don't agree with all his contrarian calls (click on image):


Denis got this chart from Angel Talavera on Twitter and it basically shows you what I'm worried about, the global economy is slowing with Eurozone leading the way and emerging markets and the US not far behind.

No wonder ECB president Mario Draghi was dovish in his statement this week, walking a very fine line between the end of QE as he tries to manage market expectations:



The euro (FXE) got crushed on Thursday and so did a lot of other currencies as the US dollar (UUP) surged close to 52-week highs:


The greenback's strength was something I predicted last year when everyone was short US dollars but it's getting a bit overdone here and along with Draghi's dovish comments, it's been wreaking havoc on emerging market currencies, stocks (EEM) and bonds (EMB) (click on images):




Now, the carnage in emerging markets isn't pretty and definitely signals a Risk-Off market. And there could be more pain ahead for emerging market stocks (EEM) and bonds (EMB) especially if trade wars escalate (click on images):



Those 5-year weekly charts above make a lot of emerging market bulls very nervous as these charts are definitely not bullish.

But Mehran Nakhjavani, Partner, Emerging Markets at MRB Partners thinks talk of an EM debt crisis is just plain silly:
There is no imminent threat of an EM debt crisis. While EM international bonds outstanding are indeed at historic highs, expressed as a share of GDP, the growth of issuance is primarily from the private sector, the latter dominated by China. For ex-China EM economies, the most recent growth has come from government issuers, with Saudi Arabia, Qatar and the UAE accounting for much of it.

As a general rule, history suggests that debt crises result from a loss of momentum of the denominator of the typical debt ratios. In other words, a deterioration in the overall ability of an economy to sustain debt and its servicing. A growth of the numerator, for example as a result of rising interest rates, is typically not the trigger for crisis, except in extreme cases.

Even if the current synchronized global economic expansion were to slow down, the debt fundamentals of many EM economies are far superior to what prevailed prior to previous EM debt crises. There will be a case to be made for impending crises in some vulnerable EM economies, but absent a 2008-style global credit crunch it is hard to see any meaningful overall threat to EM debt on a 6-12 month investment horizon.
If Mehran is right, the sell-off in emerging market stocks (EEM) and bonds (EMB) is another buying opportunity for long-term investors looking to increase their exposure to emerging markets.

Of course, there are many ways to play emerging markets here like going long the Canadian dollar (FXC) or buying US stocks like Caterpillar (CAT), Deere & Company (DE), Freeport McMoRan (FCX) or just follow Warren Buffett and buy Apple (AAPL).

But China is making people very nervous these days, including the folks at Variant Perception who think it's presenting headwinds to industrial commodities (h/t: Dan Esposito):
Our macro-driven model of expected industrial commodity returns (the CRB Raw Industrials Index includes non-exchange traded commodities such as burlap, rubber and lead scrap) has turned persistently negative, triggering the regime to shift to bearish from neutral (top left chart). This has been driven by tight Chinese liquidity conditions and the peak in global growth. The top-right chart shows that our BCFI Index has peaked and turned down, suggesting headwinds for global growth and commodity prices. Slowing EM real money growth (bottom-left chart) will also be a headwind, as is slower Chinese growth indicated by our leading indicators (bottom right chart).

So far this year, commodity markets have held up very well despite rising real yields and the recent rebound in the US dollar. This is likely reflective of late-cycle inflationary dynamics which tend to help commodities outperform as the economic cycle matures going into recessions. However, given the negative signal given by our forecast model and weak China leading indicators, for investors with industrial commodity exposures, it makes sense to buy puts to hedge against industrial-commodity price falls over the next 6 months (click on image to enlarge).


If you look at China's Large-Cap ETF (FXI), it's sitting on its 50-week moving average (click on image):


The chart isn't telling me to panic just yet, in fact, it could reverse course and head higher but all that remains to be seen.

One thing I can tell you is emerging market currencies getting slaughtered is actually good for many emerging markets relying on exports for growth. The problem, of course, is rising US protectionism can exacerbate this sell-off.

But there's a limit to what Trump and more importantly, the Fed, can do without risking a much bigger surge in the US dollar, sowing the seeds of the next global financial crisis. If Trump keeps laying tariffs and the Fed keeps raising rates, the US dollar will keep surging to new highs and that could unleash unbearable global pain.

Capiche? So take all this talk of trade wars and the Fed hiking rates a couple of more times this year with a grain of salt. If they continue on this trajectory, it's game over and they know it.

This is why I maintain that in the short run, the surge in the US dollar and sell-off in emerging markets is a bit overdone and we might see a relief rally this summer.

Longer term, however, I see a global slowdown ahead which is why I maintain a more cautious stance, especially in Q4 where we will see the creeping effects of the Fed's rate hikes start to bite.

Also, trade tensions are giving a much-needed boost to defensive stocks like Kraft Heinz (KHC), Campbell Soup (CPB)  and other consumer staple stocks (XLP) but if this turns out to a rough and not soft patch, only US long bonds (TLT) will save your portfolio from being clobbered.

One thing I can tell you, it's still a bull market in stocks but you need to pick ‘em well. Have a look at shares of Canada Goose (GOOS) today as it beat on its top and bottom line (click on image):


Its shares have more than tripled over the last year but don't chase this hot stock now (never chase any hot stock or you'll get burned alive!!).

The point I'm trying to make is turn off CNN, FOX, and CNBC, there's a lot of noise out there but in my universe, there are plenty of stocks to trade and some are doing very well (click on image):


So stop blaming Trump for everything, focus here, the market isn't breaking down just yet, there's still plenty of liquidity driving risky shares higher, you just have to pick your spots very carefully and hope the tide doesn't turn anytime soon. And again, don't chase stocks here, any stocks, because you risk being burned!

On that note, enjoy your weekend and please remember to kindly donate to this blog via PayPal on the right-hand side under my picture.

Today, I quietly celebrate my ten-year anniversary. It's been quite a journey and I want to thank those of you who have supported my efforts in every way and helped this blog achieve its success. Writing a daily blog isn't easy, far from it. It takes tremendous discipline, dedication and it's nice to see people appreciate the work that goes into it, so thank you for your support.

I will also ask many of you who regularly read this blog to please donate to the Montreal Neurological Institute here. I was diagnosed with MS exactly 21 years ago and even though it hasn't been easy, I count myself very lucky. The folks at the MNI are doing a great job helping patients with all neurological diseases so please help them any way you can. Thank you.

Below, Paul Tudor Jones, founder of Tudor Investment Corporation and the Robin Hood Foundation, speaks with CNBC's Andrew Ross Sorkin on the market reaction to US talks with North Korea, his forecast for the Federal Reserve and his take on socially responsible investing.

I don't agree with Tudor Jones's forecast on rates but this was an excellent interview, one well worth watching as he discusses many interesting topics and not just markets.

And in an exclusive interview, top-ranked portfolio strategist François Trahan explains the changing market leadership and why it’s predictable. He speaks with Consuelo Mack of WealthTrack. Great interview, I have learned a lot reading François's research at Cornerstone Macro, it's truly fantastic.