Tuesday, December 2, 2008

Why is OMERS Betting Big on Private Markets?

Wall Street rebounded today after yesterday's sharp selloff. I am not going to spend time on the stock market because I still contend that we are going to head higher going into the final stretch of the year. You should however read why Bill Gross thinks stocks are not as cheap as they appear.

Another story caught my eye today. The Ontario president of the Canadian Union of Public Employees (CUPE) has attacked the hiring of Bay Street lawyer Jacques Demers as head of a new unit of the Ontario Municipal Employees Retirement System (OMERS):

By hiring Demers, the OMERS board "lavished a multimillion-dollar compensation package on a Bay Street rookie CEO under circumstances that lack transparency and due process," Sid Ryan said Monday.

Ryan, a member of the board of the 380,000-member pension fund, said the decision "was made in haste" in a conference call Friday, instead of at a scheduled board meeting in December, and only minutes were spent on the matter.

"We're in an economic environment where the spotlight is on compensation packages of CEOs and senior executives and this board agreed to a multimillion-dollar deal without due diligence," Ryan stated.

"It's mind-boggling that OMERS directors can spend a matter of minutes on an exorbitant compensation package for a rookie at a time when workers are losing their jobs province-wide."

He said an earlier board committee meeting adjourned without recommending the hiring of Demers - who Ryan said was the only candidate being considered as president and chief executive officer of OMERS Strategic Investments.

"Workers and pensioners should be outraged at both the level of compensation and how this process was carried out."

OMERS said Friday that Demers, a senior partner with Ogilvy Renault LLP in Toronto, will focus on private investments in airports, real estate developments, energy projects and other assets.

OMERS Strategic Investments is part of a diversification drive by the pension plan, which had $52 billion in assets at the end of 2007 but like other investors has suffered in this year's financial-market meltdown.

I never met Sid Ryan but I am glad to see he is not afraid to speak his mind. I remember some OMERS pension fund managers were complaining about the board of directors at OMERS because they were simple laymen, but clearly what this board member may lack in technical knowledge, he makes up for by using good old common sense.

Let's see why OMERS is so keen on shoving billions into private asset classes, including real estate, private equity, and infrastructure.

I went to look at their annual reports to highlight the returns of various asset classes. As shown in the tables above (click on images to enlarge), OMERS made lot of money in private asset classes, easily beating the benchmarks (what a shocker!).

For example, we see that from 2005 to 2007, real estate trounced its benchmark. Private equity also did exceptionally well relative to its benchmark in those years. In 2004, we see that infrastructure returned 31% relative to its benchmark which returned 1.8% - a full 29.2% outperformance.

Clearly these benchmarks do not reflect the risks or beta of the underlying portfolio. I will repeat this: whenever someone is trouncing the benchmark by such a wide margin, that benchmark is inappropriate and therefore so is the compensation that pension fund managers are receiving.

OMERS is among the worst abusers of private market benchmarks. It's a complete joke. No wonder they want to move 40% of the portfolio in private markets!

Now more than ever, we need to make the case for disclosure:

At a recent private-equity conference Matthew Bishop, chief business writer of The Economist, argued that PE must grapple with the issue of transparency and accountability to the public. "Now that private equity has emerged into the public eye, raised a lot of money -- and even wasted a lot of money -- they have become increasingly controversial," he says. There is a real sense that Washington politics are turning quite sharply against PE and wealth creators, and that will only grow if the recession deepens and more jobs are lost, he adds.

So what does this have to do with Canada? In Canada there hasn't been a huge demand for PE firms to be more transparent because, with the exception of Onex Corp. and Brookfield Asset Management (which have private-equity type portfolios), most do smaller deals. But questions are being raised about Canada's pension funds. We have quite a few multibillion-dollar pension funds, which have taken their cue from U. S. institutions, and are largely opaque to outsiders. No one cared much when times were good and their liabilities small. But the stock market crash and a host of new reports are asking whether Canadian pension plans -- even the private ones -- should be transparent and more accountable to the public.

Claude Lamoureux, former president and chief executive of the Ontario Teachers' Pension Plan, argues no. Mr. Lamoureux makes the case that if pension plans are forced to report on a quarterly basis, they will start operating like mutual funds. The portfolio managers will feel pressure to sell on the down swings and buy hot stocks when they are priced too high.

He also argues that the OTPP is fully transparent and open with its own board, but is not beholden to disclose great amounts of information to the public. Managers, after all, don't want to share their investment strategies with competitors in the market.

[Note to Mr. Lamoureux: Yes Teachers is beholden to disclose a lot more information to the public because taxpayers will ultimately bail them out if they lose billions!]

Point taken. But there are some pretty compelling reasons for pension funds and other firms to be open to greater scrutiny. First, these large public pension funds have an enormous impact on the markets -- think of the impact of OTPP's attempted privatization of BCE. And second, if this fund remains in a deficit -- and at last look its shortfall was $12.7-billion-- then it may look to the government for a bailout. If this fund, or large private funds, seek bailouts, then the public has a right to demand transparency.

Jeff Evans helped craft the Desjardins Securities report that studied the pension liabilities of publicly traded companies in Canada. The task was difficult. The firm was only able to get a broad sense of the exposures. "What's disclosed in the financial statements versus what you need to get a handle on whether they are properly funded or not is not enough," he says. Take the big automakers, he says. The researchers couldn't get access to some basic information such as the average age of pensioners or the worker-retiree ratio. Without those characteristics it's

Funds should be open to discuss investment characteristics, objectives and risk profiles hard to determine liabilities, he argues. Mr. Evans says without oversight by the analyst community, management is free to play with the numbers. "Their rate of return on assets may be justified, but it may not be," he says. There is just no backstop.

So how much transparency should various stakeholders demand? Analysts such as Janet Rabovsky of Watson Wyatt Canada argue that while it's unnecessary to have complete "positional transparency" -- knowledge of every investment or details of major deals -- funds should be open to discussing investment characteristics, objectives and risk profiles. She also argues that while secrecy turning transactions is important, an argument could be made to disclose more details when a deal closes. "It's all about striking the right balance," she says.

Perhaps managers should apply the common sense test. When the market is good and the rates of return reasonable, various stakeholders -- and journalists -- are unlikely to clamour for funds to explain themselves. Annual reports to members and disclosure to analysts is all that's demanded.

But when deals are big or the times turbulent, institutions should be more proactive and have open communication with various stakeholders: their members, independent analysts or even the public.

Pension funds should be more proactive when it comes to communicating their results but the reality is that they prefer keeping their cards close to their chests.

Like other large pension funds, OMERS has gotten away with murder on their private market benchmarks. These benchmarks serve no purpose but to line the pockets of OMERS' senior pension officers.

I just hope they place more people like Sid Ryan on their board and less members who rubber stamp proposals. They should start by cleaning up the benchmarks for private markets.

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