Thursday, September 29, 2016

Private Equity's Misalignment of Interests?

Sebastien Canderle, author of The Debt Trap: How leverage impacts private-equity performance, sent me a guest comment (added emphasis is mine):
It usually takes a financial crisis of the magnitude witnessed in 2008 for glitches within an economic system to come to light.

It has been widely known and reported that private equity dealmakers could at times be ruthless when dealing with their portfolio companies’ management, employees and lenders. But at least these PE fund managers (general partners or GPs) were treating one party with all the respect it deserved. Their institutional investors (the limited partners or LPs) could feel appeased in the belief that the managers’ interests were aligned with their own. According to a report recently issued by research firm Preqin and entitled Investor Outlook: Alternative Assets, H2 2016, 63% of PE investors agree or strongly agree that LP and GP interests are properly aligned.

One of the most prevalent urban legends perpetuated by GPs and their PR machine is that their actions are vindicated by their sole concern to serve their investors’ interests. After all, given the 2% of annual management commissions limited partners pay to cover the GP executives’ salaries and bonuses, this argument of perfect alignment seems to make sense. But it is emphatically not the case.

Let’s review some of the many tricks that financial sponsors use to serve their own interests rather than (often to the detriment of) their LPs’. Note that the following is not meant to be an exhaustive list; just a few pointers that some LPs have come across in the past.

First, just to remind the reader, quick exits and dividend recapitalizations have one key advantage: they boost the internal rate of return (IRR), the key performance yardstick in private equity. You might think that it is a good thing for LPs, since it delivers strong performance. But actually, it is not always ideal. Upon receiving their money back, LPs then need to find a new home for the capital that has been returned to them earlier than expected.

Let me expound. What institutional investors like pension funds and university endowment departments aim to do when they commit capital to the PE sector is to yield a higher return on their money than if it was allocated to lower-risk securities. But another crucial decision criteria is to put money to work for several years (typically 6 to 10 years).

When I state ‘higher return’, there are two ways to look at it: either through the IRR or via a money multiple. The difference is that an IRR is expressed as a percentage whereas cash-on-cash return is shown as a multiple of the original investment. And the difference matters enormously.

If a GP exits after two years (via a quick flip), a 1.5-times return yields a 22.5% IRR. It is massively above the hurdle rate (usually 8%, although many larger GPs do not bother with offering any preferred return to their LPs, or they offer a lower rate). So this 22.5% yield would enable the GP to look forward to carried-interest distribution (assuming of course that the rest of the portfolio does not contain too many underperforming assets and that there is no clawback clause in the LP agreement).

But a similar 1.5-times return after six years only yields an internal rate of return of 7%, which is below the standard hurdle rate, so it will not give right to carry for the GP since it did not give LPs an adequate return for the risk they were exposed to. A six-year holding period represents a higher-risk investment for a GP. Yet, an LP would receive 1.5 times its original capital and would still be satisfied, especially if that capital had delivered lower returns in a low-coupon bond environment like the one witnessed since 2009.

Because GPs know that the time value of money affects the likelihood of their investment performance falling below the hurdle rate, they have every incentive to partially or fully realise (that is, exit) their investment as quickly as possible. Quick flips are therefore preferable to GPs, even if the LP wished to see its capital remain deployed in order to accrue further value. GPs do not care if LPs then struggle to find a new home for the capital returned too early. All a GP cares about is whether its strategy will deliver carried interest, which is why quick flips and dividend recaps are so prevalent. The time value of money explains why GPs do not always serve their LPs’ interests.

Conversely, at times GPs prefer to hold on to investee companies longer than warranted, even when they receive approaches from interested bidders. In some instances fund managers can make more money from the annual fees they charge their LPs than by selling an asset. Imagine that a portfolio company is given a value by third parties that would grant an IRR of less than 8%. It might be totally acceptable to the LP, but because it falls below the hurdle rate, it will not enable the financial sponsor to receive carry. However, if the latter retains the company in portfolio, it will continue to charge annual management fees (of 1% to 2%) on the LPs’ capital invested in that company. You understand now why some LBOs turn into long-term corporate zombies or end up spending a while in bankruptcy. As long as their financial sponsors retain ownership of the companies, they keep charging management commissions to their LPs, but as soon as control is transferred to the creditors, fees stop coming in because the investment is deemed ‘realised’.

This strategy, as old as the industry itself, was adopted by very many GPs in the years following the Credit Crunch; especially GPs who failed to raise a follow-on fund. These PE managers (themselves becoming zombie funds) simply decided to milk the assets the only way advantageous to them, even if it meant extending the life of the fund beyond the typical 10-year period. For the LPs, realising the portfolio would have been clearly preferable in order to reallocate the recovered capital to higher-yielding opportunities. But they had few means to force their fund managers to comply (since they had already refused in most cases to up their commitment in a subsequent vintage). For the GPs, charging these fees enabled the senior managers to make millions in annual bonuses for several more years without having to sell the assets.

There is more. Consider the following practice, which most GPs are guilty of. When a fund is relatively recent (say, less than five years old since its original closing), it contains a fair share of unrealised assets in its portfolio. By this I mean that a lot of acquired companies are still held in portfolio. The implication is that, when valuing the unrealised portion of the portfolio at the end of each quarter, the GP managers need to use estimates. There is a guideline issued by national trade associations to define these estimates, but there is quite a bit of wiggle room here. What prevents a GP from taking out ‘outliers’ that do not show a pretty enough comparable multiple? Many GPs tend to be quite carefree (who wouldn’t be when doing his/her own self-assessment?) by mostly using comparable multiples that grant a high valuation (and therefore a high unrealised IRR) to the portfolio.

Why do GPs bother acting that way? For several reasons, but here is the key one: imagine that the GP wants to raise a subsequent vintage to its current fund. Its existing LPs will certainly be more interested in taking part in the new vehicle if they see a high IRR (even if unrealised) as a likely outcome of the current fund. You might argue that LPs are not that gullible and will not commit further capital unless a significant portion of the portfolio has been exited and has shown good results. Yet in 2008 several funds were raised even though the 2005/06 vintages had not been fully utilised, let alone materially realised. We know what happened to these 2005/06 funds. Their performance was far from stellar.

Recent years have seen a vast number of GPs raise new vintages even though their previous funds had seen no or very few portfolio realisations. North American energy specialist investor Riverstone launched a fresh fundraise in 2014 only one year after closing its previous vehicle (Riverstone Global Energy and Power Fund V) and before having exited any investment from that vintage. Admittedly, the fundraising process lasted more than two years. This month, tech specialist Thoma Bravo closed its latest fundraise at $7.6 billion, exceeding its $7.2 billion hard cap even though it was set at practically twice the size of the $3.65 billion fund raised in 2014. British outfit Cinven raised its sixth vintage in the first half of 2016 - after just four months on the road - when it had only divested one company (out of 15 portfolio companies) from its fifth fund of 2013. Cinven VI was reportedly twice oversubscribed. French mid-market firm Astorg had exited none of the seven companies acquired out of its fund V (raised in 2011) before reaching the hard cap of its fund VI in June 2016. Similarly, Australian shop Quadrant raised its fifth fund in August 2016 (on its first close) only two years after raising the previous vehicle. Quadrant PE No4 had exited none of its five investments. All these GPs had to use interim IRRs in order to raise fresh vintages despite the lack of meaningful exit activity from their previous vehicles. Time will tell whether the reported unrealised IRRs were realistic, but LPs do not seem too bothered by the very high-risk profile of immature vintages.

There is another reason why, traditionally, GPs artificially inflated their unrealised IRRs. In the early days of the sector’s history, PE managers used to be able to raise funds without granting LPs any right to the aforementioned clawback. Clawbacks are ways for institutional investors to recoup previously distributed carry if the GP manager’s performance at the end of the life of the fund falls below the hurdle rate. Nowadays, the vast majority of PE funds’ agreements include a clawback clause, but years ago it wasn’t always so, which explains why GPs tended to ‘tweak’ IRR calculations to their advantage and distribute themselves carried interest on the basis of high unrealised returns. Why not do it if you can get away with it.

Anyone telling you that GPs only care about maximising returns is just a scandalmonger. In truth, GPs care even more about charging fees, primarily because two-thirds of GPs never even perform well enough to receive any carried interest. Thus, I cannot possibly draw a list of LP/GP interest misalignment without raising the issue that has made front-page news (at least in the specialised press) in the years following the financial crisis.

The debate that has been taking place around management and monitoring fees and the double-charging by GP managers is not new, but it looks like even the foremost LPs committing billions of dollars to the sector failed to keep track of how much they were being charged annually by their GPs. Perhaps this is why, according to the aforementioned Preqin report, two-thirds of investors consider that management fees remain the key area for improvement and more than half of respondents are asking for more transparency and for changes in the way performance fees are charged.

In 2015, high flyers KKR and Blackstone were fined by the Securities and Exchange Commission $30 million and $39 million respectively for, allegedly, failing to act in the interest of their LPs in relation to deal expenses and fee allocation. Similarly, following another S.E.C. investigation, in August of this year their peer Apollo was slapped with a $53 million fine for misleading investors on fees. The issue of fee transparency and conflicts of interest is unlikely to be restricted to the mega segment of the industry. So there might be more bad news to come if the regulators choose to pursue the matter further.

Again the foregoing list is not meant to be exhaustive, but it serves to demonstrate that the alignment of interests between private equity GPs and LPs is kind of a myth. It took a financial crisis to remind everyone of this evidence, though based on Preqin’s research, not all investors seem aware of it.
You will recall Sebastien Canderle has already written another guest comment on my blog, A Bad Omen For Private Equity?, which I published in November last year.

Sebastien was kind enough to forward me this comment after he read my last comment on why these are treacherous times for private equity. I sincerely thank him as he is a PE insider who worked for four different GPs during a 12-year stretch, including Candover and Carlyle in London.

In other words, he knows what he's talking about and doesn't mince his words. He raises several important issues in the comment above and while some cynics will dismiss him as wanting to sell his book, I would buy his book, read it carefully and take everything he writes above very seriously.

We talk a lot about risk management in public markets but what about risk management in private markets where too many LPs don't devote enough resources to really take a deep dive and understand what exactly their private equity and real estate partners are doing, what risks they're taking, and whether they really have the best interests of their investors at heart.

I used to invest in hedge funds at the Caisse and saw my fair share of operational screw-ups which could have cost us dearly. When I moved over to PSP, I worked on the business plan to introduce private equity as an asset class and met GPs and funds of private equity funds. I used my due diligence knowledge in hedge funds to create a due diligence questionnaire for private equity GPs. It's obviously not the same thing but there are a lot of issues which are in common and I really enjoyed meeting private equity GPs.

Unlike hedge fund managers -- and I've met some of the very best of them -- top private equity GPs are all very polished, and when they're good, they can close a deal with any LP. I remember a presentation given by fund managers at Apax Partners at our offices at PSP in Montreal. When they were done, Derek Murphy, the former head of private equity at PSP looked at me and said: "Man, they're good, they covered all the angles. You can tell they've done this plenty of times before."

Interestingly, Derek Murphy is now the principal at Aquaforte Private Equity, a Montreal company he set up to help Limited Partners (LPs) establish "aligned, high-performing, private equity partnerships" with General Partners (GPs). You can read all about what they do here.

I don't mind plugging Derek's new firm. Someone told me he's "too scared" to read my blog which made me chuckle but if you're an LP looking to improve your alignment of interests with private equity GPs, you should definitely contact him here (rumor has it his boxes were packed the minute PSP announced André Bourbonnais was named PSP's new CEO and he quit shortly after knowing their styles would clash).

Anyways, I really hope you enjoyed reading this comment even if it shines a critical light on deceptive practices private equity GPs routinely engage in. Trust me, there are plenty more but Sebastien's comment above gives many of you who don't have a clue about private equity how private equity's alignment of interests with LPs are often totally screwed up.

Those of you who want to learn more on private equity as an asset class can read Sebatien's books here as well as the links on my blog on the right-hand side. I also recommend you read Guy Fraser-Sampson's book, Private Equity as an Asset Class (first edition is available for free here), as well as other books like Private Equity: History, Governance, and Operations, Inside Private Equity, and one of my favorites, Thomas Meyer's Beyond the J Curve: Managing a Portfolio of Venture Capital and Private Equity Funds.

The problem these days is too many so-called experts are too busy to read and learn anything new. They think they know a lot but they've only scratched the surface. My philosophy is to never stop reading, learning and sharing. And if you have expert insiders like Sebastien Canderle offering you something worth publishing, you take it and run with it.

Hope you enjoyed reading this comment, please remember to kindly show your financial support for the work that goes into this blog by subscribing or donating via PayPal on the right-hand side under my picture.

Below, Bronwyn Bailey, Vice President at Private Equity Growth Capital Council (now called American Investment Council), outlines why transparency is important for LPs and GPs. This clip was filmed at SuperReturn International 2016.

You can also watch a Privcap discussion on Why Fee Transparency is the New Reality to gain more industry insights on this important topic.

Like I said in my last comment on why these are treacherous times for private equity, even though regulators are placing the screws on the industry, I take all this talk on increased transparency with a shaker, not a grain of salt.

If you want to know what is really going on in private equity, you need to read insights from insiders like Sebastien Canderle who expose some deeply held myths on alignments of interests in the industry.

Wednesday, September 28, 2016

Treacherous Times For Private Equity?

Devin Banerjee of Bloomberg reports, Blackstone’s Top Dealmaker Says Now Is The Most Difficult Period He's Ever Experienced:
Joe Baratta, Blackstone Group LP’s top private equity dealmaker, can’t be too cautious right now.

“For any professional investor, this is the most difficult period we’ve ever experienced,” Baratta, Blackstone’s global head of private equity, said Tuesday, speaking at the WSJ Pro Private Equity Analyst Conference in New York. “You have historically high multiples of cash flows, low yields. I’ve never seen it in my career. It’s the most treacherous moment.”

Private equity managers have tussled with a difficult reality for several years. The same lofty valuations that created ideal conditions to sell holdings and pocket profits have made it exceedingly difficult to deploy money into new deals at attractive entry prices. Several executives, including Blackstone Chief Executive Officer Steve Schwarzman, have pinned those conditions squarely on the Federal Reserve’s near-zero interest rate policies.

Baratta, 45, said Blackstone isn’t finding value in large leveraged buyouts of publicly traded companies. Instead, the New York-based asset manager is targeting smaller companies with low leverage, he said.

‘Net Sellers’

The firm is still selling more assets than it’s buying, according to President Tony James.

“We’re net sellers on most things right now -- prices are high,” James said in a Bloomberg Television interview Tuesday. “Interest rates are so low and there’s so much capital sloshing around the world.”

Blackstone finished gathering $18 billion for its latest private equity fund last year. The firm also has an energy private equity vehicle, which finished raising $4.5 billion last year.

Blackstone is close to striking its first deal by a new private equity fund, called Blackstone Core Equity Partners, Baratta said. The vehicle will have a 20-year life span, double the length of a traditional private equity fund.

The core equity fund, which has gotten $5 billion so far, will deploy $1 billion to $3 billion per deal, said Baratta. The transaction the firm is working on is valued at about $5 billion including debt, he said, without elaborating.

Blackstone, founded by Schwarzman and Peter G. Peterson in 1985, managed $356 billion in private equity holdings, real estate, credit assets and hedge funds as of June 30.
No doubt, these are treacherous times for private equity, hedge funds and especially active managers in public markets.

Facing dim prospects, Jon Marino of CNBC reports the barons of the buyout industry are now looking to buy each other out:
The barons of the buyout industry may need to buy one another out next.

KKR, the private equity firm co-founded by Henry Kravis, reportedly sought to tuck lender and investment firm HIG Capital under its growing corporate credit wing. That would mean adding about $20 billion in assets to Kravis' company. Neither firm responded to a request for comment.

That's not all; HarbourVest Partners, perhaps looking to take advantage of the discounted pound in the U.K., submitted a bid to buy SVG Capital, a British firm, but was rebuffed late last week. SVG Capital told HarbourVest, which is based in Boston, that it felt the bidder's offer came up short — and revealed it has had talks with other "credible parties," as well.

For some, it's the right move, in order to beef up assets under management.

Public markets haven't been too friendly to private equity firms' initial public offerings, and as their senior leaders consider ways to exit long-held positions in their companies, options to net a return are dwindling. Tacking on other businesses could at least help juice management fees for buyers.

But for other private equity firms, it may be the only other option, beyond becoming zombie funds or winding down in the long run.

"The bloom has come off the rose for many big private equity firms," said Richard Farley, chair of the leveraged finance group at law firm Kramer Levin.

The urge to merge in the private equity industry should be growing, and it comes at a tough time for the private equity industry. Funding could become scarcer, as general partners leading top leveraged buyout firms are weighing whether to do deals. Some of their primary sources of cash — public pensions — are withdrawing from the business, in part because of abusive fee practices at certain firms.

Beyond the secular industry pressures faced by private equity firms, their returns have been compressed by a number of legislative and regulatory measures in the U.S.

In the wake of the global financial crisis, Washington regulators forced banks that fall under the purview of the Treasury Department and the Federal Reserve to scale back how much they lent to private equity buyers' deals, relative to the earnings before taxes, depreciation and amortization of those companies. Broadly speaking, banks are not permitted to lend more than six times a company's Ebitda to get a deal done.

Further, leading up to this election there has been a great deal of hand-wringing by private equity executives that carried interest taxation, which allows them to be taxed at around half the going rate ordinary Americans face, may rise in coming years, further crimping profits. One legislative expert, asking to not be quoted, suggested it will remain difficult to pass legislation targeting carried interest, in part because other financial services sector businesses beyond private equity count on the tax break.

"Washington probably isn't private equity's biggest enemy," the source said. "The real pressures are that the industry can't generate the same kinds of returns their investors got used to."
Indeed, the (not so) golden age of private equity is long gone and investors better get used to the industry's diminishing returns. Just look at the private equity returns at CalPERS and other large pensions I cover in this blog, they have been declining quite significantly.

Moreover, the industry faces increased regulatory scrutiny and increased calls to be a lot more transparent on all the fees levied on investors, not that these initiatives are going anywhere.

In April of last year, I warned my readers to stick a fork in private equity. The point I made in that comment was the industry is far from dead but it's undergoing a major transformation and facing important secular headwinds in a low yield/ high regulatory environment.

Even the best of the best private equity firms, like Blackstone, realize they need to adapt to the changing landscape or risk major withdrawals from clients.

In response, private equity's top funds are looking to merge and they're discovering Warren Buffett's approach may indeed save them from extinction or at least help them navigate what is increasingly looking like a prolonged debt deflation cycle.

There's a reason why Blackstone's new fund, called Blackstone Core Equity Partners, will have a 20-year life span, double the length of a traditional private equity fund. Blackstone is implicitly telling investors to prepare for lower returns ahead and it will need to adopt a much longer investment horizon in order to produce better returns over public markets.

This isn't a bad thing. In fact, by introducing new funds with longer life spans, private equity funds are better aligning their interests with those of their investors. They are also able to garner ever more assets (at reduced fees) which will help them grow their profits. And the name of the game is always asset gathering but it helps when these funds outperform too.

Let me end by informing my readers that Canada's West Face Capital is aiming to raise $1.5 billion for a new private equity fund to make larger investments:
“We believe attractive market dislocations could occur over the next few years and we are making preparations with our investing partners,” Greg Boland, the head of Toronto-based West Face, said in an e-mail, declining to comment on the details of the fundraising. “The new committed draw fund will augment our ability to respond to large opportunities.”

West Face has reached out to potential investors about the new fund, which will invest in private and public securities and seek control through distressed transactions, said the person, who asked not to be identified because the matter is private.

The hedge fund is touting a 14 percent year-to-date return on its open-ended core fund in the fundraising efforts, the person said.

West Face focuses on event-oriented investing, specializing in distressed situations, private equity, public market investments and other transactions. The fund has been involved in several high-profile investments in recent years, including leading a group who acquired wireless carrier Wind Mobile in September 2014. That business was sold about 15 months later for C$1.6 billion ($1.2 billion) to Shaw Communications Inc., netting a sixfold return for the acquirers.
Not bad at all, while most hedge funds are struggling, some are still delivering exceptional returns and I like reading about Canadian hedge funds that are doing well.

By the way, a friendly reminder that the first ever cap intro conference for Quebec and Ontario emerging managers is taking place next Wednesday, October 5th, in Montreal. Details can be found here.

Also, another conference taking place in Montreal next week (October 5 and 6) is the AIMA Canada Investor Forum 2016. You can find details on this conference here.

I have decided to do my part to cover the first conference as it's important to help emerging managers get the decent exposure they deserve and I haven't decided whether I will attend the AIMA conference but there are some very good panel discussions taking place there.

Below, Tony James, president and chief operating officer at Blackstone, recaps the first US presidential debate and looks at market reaction to the election and the impact of geopolitical risk out of Europe.

James also addresses the challenges American workers face in saving for retirement and the need for a raise in the federal minimum wage. He speaks with Bloomberg's Erik Schatzker on "Bloomberg Markets."

The sad reality is that baby boomers aren't retiring because they can't afford to. And while I've openly criticized Tony James and Teresa Ghilarducci's "revolutionary retirement plan", I completely agree with James that rising inequality is impacting aggregate demand not just in the US but all over the world, and this is deflationary, keeping a lid on growth for a very long time.

Tuesday, September 27, 2016

Teachers' Cuts Computer-Run Hedge Funds?

Maiya Keidan of Reuters reports, Canada public pension plan ditches 10 computer-driven hedge funds:
Canada's third-largest public pension plan has halved the number of computer-driven hedge funds in its investment portfolio and put more money into the funds its sticking with, sources with knowledge of the matter told Reuters.

The Ontario Teachers' Pension Plan this summer pulled cash from 10 of the 20 hedge funds in its portfolio which use computer algorithms to choose when to buy and sell, two of the sources said.

Ontario Teachers' allocates $11.4 billion to hedge funds, making it the fourth-largest North American investor in the industry, data from research house Preqin showed.

Hedge funds worldwide are under increasing pressure in the wake of poor or flat returns as well as investors' efforts to cut costs. Data from industry tracker Eurekahedge showed that investors have pulled money from hedge funds globally every month in the four months to end-August.

One of the hedge funds that received more funds from the Ontario Teachers' Pension Plan said it had told them it was looking for funds which offered a different strategy from other funds.

"They expressed that a lot of strategies today you can mimic with a few exchange-traded funds or create synthetic products and there is no reason to pay management or performance fees," the source said.

Another hedge fund which the Canada fund dropped said the pension scheme had said it wanted to avoid funds invested in similar underlying assets.

Some of the computer-driven hedge funds the Ontario Teachers' pulled money from followed market trends, such as Paris-based KeyQuant, which has more than $200 million in assets under management, according to its website.

The Ontario scheme also withdrew $65 million in June from trend-follower Cardwell Investment Technologies, a move which ultimately led to it shutting its doors this summer, one of the sources said.

Those funds to receive a boost offered a more specialist set of skills, such as London-based computer-driven currency hedge fund Sequoia Capital Fund Management, in which the pension fund doubled its investment, a second source said.
I reached out to Jonathan Hausman, Vice-President, Alternative Investments and Global Tactical Asset Allocation at Teachers' in an email earlier today to discuss this latest move and copied Ron Mock on it.

But knowing how notoriously secretive Ontario Teachers' gets when it comes to discussing specific investments and investment strategies, especially their hedge funds, I doubt either of them will come back to me on this matter (if they do, I will edit my comment).

Those of you who never met Jonathan Hausman, there is a picture of him now sporting a beard on Teachers' website along with his biography (click on image):


Jonathan is in charge of a very important portfolio at Ontario Teachers. While most pensions are exiting hedge funds after a hellish year or seriously contemplating of exiting hedge funds, Teachers invests a hefty $11.4 billion in hedge funds, representing roughly 7% of its total portfolio.

While the absolute amount is staggering, especially relative to its peer group, you should note when Ron Mock was in charge of external hedge funds, that portfolio represented roughly 10% of the total portfolio and it had a specific goal: obtain the highest portfolio Sharpe ratio and consistently deliver T-bills + 500 basis every year with truly uncorrelated alpha (overlay strategy).

[Note: When Teachers had 10% invested in hedge funds and hit its objective, this portfolio added 50 basis points+ to their overall added-value target over the benchmark portfolio with little to no correlation to other asset classes. The objectives for external hedge funds are still the same but the overall impact of this portfolio has diminished over the years as hedge fund returns come down, other more illiquid asset classes like infrastructure, real estate and private equity take precedence and Teachers expands its internal absolute return strategies where it replicates these strategies internally, foregoing paying fees to external managers.]

So why is Ontario Teachers' cutting its allocation to computer-run hedge funds? I've already discussed some reasons above but let me go over them again:
  • Underperformance: Maybe these particular hedge funds were underperfoming their peers or not delivering the return objectives that was asked of them.
  • Strategy/ portfolio shift: Unlike other investors, maybe the folks running external hedge funds at Teachers think the glory days of computer-run hedge funds are over, especially if volatility picks up in the months ahead (read this older comment of mine). Maybe they see value in other hedge fund strategies going forward and want to focus their attention there. Teachers has a very experienced hedge fund group and they are very active in allocating and redeeming from external hedge funds.
  • Internalization of absolute return strategies: Many popular hedge fund strategies can be easily replicated internally at a fraction of the cost of farming them out to external hedge funds, foregoing big fees and potential operational risk (I used to work with a very bright guy called Derek Hulley who is now a Director of Data Science at Sun Life who developed such replication strategies for his former employer and since he traded futures, he had intimate and detailed knowledge of each contract when he programmed these strategies, which gave his replication platform a huge advantage over other more generic ones.)
  • Cut in the overall allocation to hedge funds: Let's face it, it's been a hellish few years for hedge funds and all active managers. If you're a big pension or sovereign wealth fund investing billions, do you really want to waste your time trying to find hedge funds or active managers that might outperform or "add alpha" in public markets or are you better off directly investing billions in private equity, real estate and infrastructure over the long run? 
That last question is rhetorical and I'm not claiming Teachers is cutting its allocation to hedge funds (obviously not) but many of its peers, including the Caisse, have drastically cut allocations to external hedge funds to focus their attention on highly scalable illiquid asset classes.

Now, we can argue whether we are on the verge of a hedge fund renaissance or whether active managers could be ready to shine again but the point I'm making is most large pensions and sovereign wealth funds are more focused on directly or indirectly investing huge sums in illiquid alternatives and I don't see this trend ending any time soon.

In fact, I see infrastructure gaining steam and fast becoming the most important asset class, taking over even real estate in the future (depending on how governments tackle their infrastructure needs and entice public pensions to invest).

I will end with a point Ron Mock made to me when I went over Teachers' 2015 results. He stressed the importance of diversification and said that while privates kicked in last year, three years ago it was bonds and who knows what will kick in the future.

The point he was making is that a large, well-diversified pension needs to explore all sources of returns, including liquid and illiquid alternatives, as well as good old boring bonds.

And unlike other pensions, Ontario Teachers has developed a sophisticated external hedge fund program which it takes seriously as evidenced by the highly trained team there which covers external hedge funds.

I was saddened (and surprised) to learn however that Daniel MacDonald recently left Ontario Teachers to move to San Diego where he now consults institutions on hedge funds (his contact details can be found on his LinkedIn profile).

Daniel is unquestionably one of the best hedge fund analysts in the world and one of the sharpest and nicest guys I ever met at Teachers. aiCIO even called him one of the most influential investment officers in their forties (click on image):


He's even won investor intelligence awards for his deep knowledge of hedge fund investments and none of this surprises me. His departure represents a huge loss for Ontario Teachers' external hedge fund group.

Below, CNBC's Kate Kelly reports hedge fund Perry Capital is closing its flagship fund after 28 years in the business. No surprise to me, it's a hellish year for hedge funds, and many marquee names are feeling the heat from investors who are fed up paying outrageous fees for mediocre returns.

Monday, September 26, 2016

Caisse Bets Big On India's Power Assets?

Abhineet Kumar of India's Business Standard interviewed Prashant Purker, Managing Director & CEO of ICICI Venture Funds, who said they will acquire power assets worth $3.5 billion:
This month, came up with a new investment platform to acquire conventional power assets. The fund comes at a time when capital goods maker Bharat Heavy Electricals (BHEL) is seeing 45 per cent of its Rs 1.1-lakh core order book face the challenge of stalled or slow moving projects. A large number of this are stuck due to financial constraints that ICICI Venture’s power platform plans to benefit from. Prashant Purker, managing director and CEO of ICICI Venture Funds, spoke to Abhineet Kumar on his plans for that. Edited excerpts:

What is the worth of assets you are targeting to acquire with your $850-million power platform?

We’re targeting to acquire $3-3.5 billion worth of (enterprise value) assets in the conventional power segment across thermal, hydel (hydro electric) and transmission businesses.

Clearly, there are a lot of power assets just getting completed or stuck in the last mile of completion with over leveraged situations at company or sponsor level. They need someone who can buy the assets out, inject equity to complete the project and have the capability to operate these assets on a long-term basis. This platform provides that — Tata Power bring operating capabilities and ICICI Venture provide fund management service as sponsors for the fund.

In return, these assets benefit those investors who need long-term yields. This is ideal for our investors such as Canadian pension fund CDPQ (Caisse de depot et placement du Quebec) as well as sovereign funds Kuwait Investment Authority and State General Reserve Fund of Oman.

As a funds-house, what is your strategy for platforms? Can we expect more such platforms to come in the future?

In 2014, we collaborated with Apollo Global Management to raise first special situation funds for India. We raised $825 million under our joint venture AION Capital Partners. Unlike funds, platforms are dedicated to some sort of investments where assets can be aggregated. Our strategy is to identify situations or opportunities in the market that require certain things to be brought together and then bring it with whatever it takes.

With the pedigree and group linkage, ICICI Venture is in a unique position to achieve this. Among domestic institutions, it is the only one which is truly multi-practice with four investment teams across private equity (PE), real estate, special situation and power assets. Across these four, we have $4.15 billion assets under management and it does not include the fund we raised in the venture capital era. Today, we have the largest dry powder of $1.5 billion across these funds.

It has come with our ability to spot opportunity earlier, and bring together whatever it takes. We will continue to look for new platform opportunities.

What is the update on your PE and real estate funds?

For real estate, we’ve total assets under management of $625 million with two funds fully invested. Now we plan to raise our third fund and have applied to the regulator for approval.

For PE, we are in the process of raising our fourth fund and have concluded interim closing as well as the first two investments. We have also started investing from our fourth fund with a couple of investments — Anthea Aromatics and Star Health Insurance — already made. Our PE fund will remain sector-agnostic and look for growth capital investment opportunities coming from rising consumption. In terms of exits, we have returned nearly half of our third fund to investors from various exits with Teamlease being the latest one where we used the IPO (initial public offering) route. Exit from the rest of the investee companies from the third fund is in the process of using multiple routes of IPOs, secondary sale, or strategic sell-off.

What is the sense you get on limited partners' view for investments in India as you raise your fourth PE fund?
Limited partners are today happier with exits position than they were a couple of years ago. Obviously, markets can’t just keep absorbing the capital; it has to return. With IPO markets opening up and given the increasing number of secondary deals, the sentiment for investments has improved. We are also seeing larger traction for strategic buy-outs as Indian promoters are fine with giving up controls. Is it that people are hundred per cent convinced to come to India - we are not in that position. People are looking for quality managers. Many funds would not be able to raise money as investors now want to gravitate to a few who have delivered returns and have a track record to show.

As disruption affects businesses across industries, how prepared are your investee companies to face it?


Today, every company has to be on its toes to look at technology – be it health-care or banking. At every company’s board, directors with grey hair are asking about social media presence and how customers are being acquired. So, technological disruption has become truly mainstream.

It is an ongoing process, and they are today definitely more prepared than they were two years back.
Good interview with a bright person who is obviously very well informed on what is going on in India and the opportunities that exist there across private markets.

I bring this particular interview to your attention not because I know Prashant Purker or want to plug but because they have some very savvy investors on board including the Caisse and Kuwait Investment Authority. 

Why are these two giant funds investing in India's power assets? Because it's an emerging market that is growing fast and if pensions find the right partners, they can benefit from this growth investing in public and private markets. 

Power assets are in line with the Caisse's philosophy under Michael Sabia's watch, ie. slow and steady returns, which is why it doesn't surprise me that they opted to invest in this new platform which will invest in power assets that provide a steady long-term yield. 

And the Caisse isn't the only large Canadian pension fund investing in India. Many other Canadian pension funds invest in India, including the Canada Pension Plan Investment Board (CPPIB) which opened a new office in Mumbai last year to focus on investment opportunities across the Indian subcontinent.

Are there risks investing in India? Of course there are. Extreme poverty, gross inequality, rampant corruption and war with Pakistan are perennial concerns, but this emerging market has tremendous long-term potential even if the road ahead will undoubtedly be very bumpy. And unlike China, India is a democracy with favorable demographics but its infrastructure is nowhere near as developed as it is in China.

As you can see below, one thing India has in common with China is problems with its pension system. The Real News Network reports on why 150 million Indians recently took to the streets to protest in of the largest one day strike in history.

I think India should follow China which is seeking aid from Canada's CPPIB to reform its state pensions.

Also, Press TV reports that bilateral ties between India and Pakistan have further deteriorated following the recent attack on Indian army soldiers in north Kashmir. New Delhi accused Islamabad of being behind the attack, with Pakistan rejecting the accusation.

Let's hope this situation doesn't disintegrate any further than it already has and that these two neighboring countries can coexist peacefully for many more decades.



Friday, September 23, 2016

CPPIB to Aid China With Pension Reform?

Rob Kozlowski of Pensions & Investments reports, CPPIB to aid China with pension reform, other issues:
Canada Pension Plan Investment Board, which manages the assets of the C$287.3 billion ($217.4 billion) Canada Pension Plan, Ottawa, signed a memorandum of understanding with the National Development and Reform Commission of the People’s Republic of China to offer its expertise to the country on a variety of issues, a CPPIB news release said Thursday.

The memorandum of understanding includes the CPPIB assisting China’s policymakers “as they address the challenges of China’s aging population, including pension reform and the promotion of investment in the domestic senior care industry from global investors,” the news release said.

“As we continue to deploy capital in important growth markets like China for the benefit of CPP contributors and beneficiaries, there is significant value for a long-term investor like CPPIB in sharing information, experience and successful practices with policymakers as they work toward improving policy frameworks,” said Mark Machin, CPPIB’ president and CEO, in the news release. “We are (honored) to have the opportunity to share our perspective and expertise with Chinese policymakers to tackle the issues of providing for an aging population.”

CPPIB will offer joint training, workshops and pension reform research as well, the news release said.

The memorandum was signed Thursday as part of bilateral agreements between China and Canada. In January, the CPPIB was designated by the China Securities Regulatory Commission for renminbi qualified foreign institutional investor status, granting it broad access to China’s capital markets.
Jacqueline Nelson of the Globe and Mail also discusses this agreement here (subscription required). You can read the news release on CPPIB's website here.

What are my thoughts? I generally think any bilateral trade agreement with China is a good thing, and the fact the Chinese seized this opportunity to forge stronger ties with Canada's largest pension fund speaks volumes on the respect they have for Canada's large, well-governed pensions.

A couple of weeks ago, I discussed the global pension crunch, highlighting the problems Chinese policymakers face with their state pensions, many of which are chronically underfunded and need to be shored up as the population ages and benefits need to be paid out.

And this at a time when China has a $2 trillion black hole to deal with.

In April, I discussed China's pension gamble, criticizing the use of pensions to inflate stock prices higher as an irresponsible policy which will hurt the Chinese market in the long run.

What can the Chinese learn from CPPIB? A lot. First and foremost, they cam learn the benefits of good governance and why it's crucial for their state pensions' long-term success. Admittedly, good governance isn't something that comes easily in China where the government interferes in everything but this is something that needs to be changed.

Second, they can learn all about the benefits of three major structural advantages that are inherent to the CPP Fund – long horizon, scale, and certainty of assets; and three developed advantages that result from strategic choices they have made – internal expertise, expert partners, and Total Portfolio Approach (click on image below).


Together, these advantages provide CPPIB with a distinct perspective for investment decision-making.

Most importantly, China's large pensions can forge ties with CPPIB and invest alongside it in big private market deals in China, Asia and elsewhere. This is a win-win for all parties which is why I'm glad they signed this memorandum of understanding.

Unfortunately, all is not well between Canada and China. In particular, I'm a bit concerned when I read Joe Oliver, the former Conservative minister of finance, writing a comment in the National Post saying, We have no choice but to slap a tax on Toronto houses being bought by foreigners.

Really? Apart from being discriminatory against foreigners (ie., Chinese), these taxes don't address the root cause of lack of affordable housing in Vancouver and Toronto -- the lack of supply!! -- and they were hastily implemented to appease the poor and middle class without careful consideration how they will negatively impact the economies of British Columbia and Ontario.

A friend of mine who lived in Vancouver and moved back to Montreal put it succinctly when he read CIBC said that Ontario will need to implement foreign buyer tax on housing:
No surprise. This is now a political issue. It is about fighting for the poor rather than protecting the wealth generated by the influx of Chinese. The government has now started the snowball and it will be difficult to reverse.

Very shortsighted thinking. There were many ways to tackle the problem which could have accomplished both objectives (protect wealth and restore some balance to the market). It would have taken longer and been less dramatic.

Everyone outside of Vancouver assumes that this is simply a demand-side issue and that by curbing "Chinese" demand, the problem will go away.  It won't. It will certainly cause a temporary haircut at the upper end of the market but even after a 50% haircut, the average Joe will not have the means to buy property.

The only way to solve this is to create supply and to do this, the government needs to release land from the agricultural land reserve for development of affordable single family housing.  They have done it before (in White Rock).

They also need to allow construction up and over the mountains on the North Shore. Yes this means cutting down trees and laying havoc to the landscape but there really is not a lot of choice here.

What they are doing now is basically driving away the Chinese and their investment dollars. When you look at the BC economy, they really cannot afford to do this.
No kidding. Bloomberg reports, Foreign Buying Plummets in Vancouver After New Property Tax:
Foreign investors dropped out of Vancouver’s property market last month after the provincial government imposed a 15 percent surcharge to stem a surge in home prices:

Overseas buyers accounted for less than 1 percent of the C$6.5 billion ($5 billion) of residential real estate purchases between Aug. 2 to 31 in Metro Vancouver, according to data released by British Columbia’s Ministry of Finance on Thursday. In the roughly seven weeks prior to that, they’d represented 17 percent of transactions by value.

The Canadian city, nestled between the water and soaring mountains, has long been a favored destination among global property investors, who have been blamed for fomenting escalating prices. The new tax went into effect Aug. 2 amid public pressure in the region, where home prices are almost double the national average of C$473,105.

The plunge in foreign participation joins other signs of a slowdown in Canada’s most expensive property market. Vancouver home sales fell 26 percent in August from a year earlier, while the average price of a detached property declined to C$1.47 million, the lowest price since September 2015, according to the Real Estate Board of Greater Vancouver.

The latest data shows that overseas buyers snapped up C$2.3 billion of homes in the seven weeks before the tax was imposed, and less than C$50 million in the next four weeks. The government began collecting data on citizenship in home purchases on June 10. The ministry said auditors are checking citizenship or permanent residency declarations made by buyers and also reviewing transactions to determine if any were structured to avoid tax.

Across the province, the participation of foreigners dropped to 1.4 percent of transactions by value in August, from 13 percent in the preceding seven weeks.

British Columbia has raised C$2.5 million in revenue from the new levy since it took effect. Budget forecasts released last week indicated that the Pacific coast province expects foreign investors to scoop up about C$4.5 billion of real estate through March 2019.
I bring this issue up because while critics love pointing the finger at Chinese policymakers when they make dumb decisions, maybe we Canadians need to reflect more on the bonehead moves our policymakers take to "defend the poor and working class" (exactly the opposite will happen as Chinese move to Seattle but maybe this will boost Calgary and Montreal's real estate market).

Anyways, enjoy your weekend and remember, behind the trade agreement with China, there's an equally important agreement on the pension front which will also benefit Canadians and the Chinese. This is undeniably great news for both countries.

Below, Chinese Premier Li Keqiang is on Parliament Hill for the first visit to Canada by a Chinese leader in six years. Canadian Prime Minister Justin Trudeau says Canada is exploring a free trade agreement with China, as he hosts his Chinese counterpart in Ottawa.

And take the time to listen to an AVCJ interview with Mark Machin, President and CEO of CPPIB, which took place last year when he was head of international and Asian investments. Listen carefully to his comments and you will realize why China is forging ties with CPPIB to reform its pensions.