Sunday, January 31, 2010

Pensions Regain Faith in Hedge Funds?

Sam Jones and Kate Burges of the FT report that Pension schemes regain faith in hedge funds:

The number of pension schemes looking to invest money with hedge funds doubled during 2009, according to a leading investment consultancies.

Hewitt Associates has seen inquiries from clients increase sharply as pension fund trustees scrabble to find high-performing investment strategies to help recoup losses suffered in 2008.

“A lot of institutional investors have got over the emotional block that hedge funds are risky products that they should be scared of. Clients are much more comfortable with the asset class,” Guy Saintfiet, a senior hedge fund researcher at Hewitt told the Financial Times.

Other consultants – which play a crucial role as intermediaries in guiding pension funds’ investments – also report a change in attitudes towards hedge funds. According to Damien Loveday, a senior investment consultant at Towers Watson, pension fund trustees had become more sophisticated. Most UK schemes were now looking to allocate up to 15 per cent of their portfolio to hedge funds, Mr Loveday said.

Pension fund managers are also looking to make allocations directly to hedge fund managers. In the past, institutional investors have preferred exposure via a fund of funds, which pools money and makes diversified investments.

Several of the largest pension funds have already indicated that they are looking to make significant direct allocations to hedge fund managers. The £28bn University Superannuation Scheme – the UK’s second largest pension plan – said on Tuesday it expected to invest with as many as 30 managers during the next two years. Its investments will add up to £1.4bn.

In the US, Calpers, the world’s largest pension scheme, said in its end-of-year statement that it had conducted due diligence on 66 hedge funds. Like many of its peers, it has yet to make any investment.

According to BarclayHedge, the industry data provider, inflows into hedge funds have only just returned to pre-crisis levels.

“The inflow of $54bn [£34bn] in the latest four months reversed only a small portion of the redemptions of $402bn from September 2008 through July 2009,” said Sol Waksman, BarclayHedge chief executive.

But this year will see actual pension fund allocations rise significantly, according to Hewitt. “Some of the allocations clients are ready to make are very significant,” Mr Saintfiet said.

Such large allocations are not just for the largest hedge funds either. The New York State Common Retirement Fund allocated $250m last week to Finisterre, the London-based emerging markets fund, which manages just under $1bn.

Let me remind these pension parrots of a few things. First, 2009 was all about beta. No surprise that hedge funds came back from the brink as most of them are taking leveraged beta bets. Second, going forward, it's going to be all about alpha. While going the direct route makes sense (avoid the double layer of fees of funds of funds), the reality is that the majority of pension funds heavily rely on pension consultants to conduct a proper due diligence on these hedge funds. Some of these consultants are good, most are pathetic. Same goes for funds of funds.

Third, and most importantly, hedge funds are not out of the woods yet. Margot Patrick of Dow Jones reports in the WSJ, Despite Gains, Most Hedge Funds Can't Make Performance Fees:
Despite average 20% returns last year across the industry, most hedge funds still weren't collecting performance fees at the end of 2009 because they hadn't fully recouped investment losses in the financial crisis.

According to data from Hedge Fund Research Inc., just 31% of funds were in a position to collect performance fees at the end of the fourth quarter. HFR estimates that just over 50% of funds reached their "high water marks" some time in 2009, but not all of them stayed above that level.

Until funds get back to their high points, managers usually can't collect performance fees--typically around 20% of any gains. Without that extra money, hedge fund firms can struggle to keep paying staff out of management fee income--usually 2% of investors' capital. It also gives employees less of an incentive to stay on board, if they could instead get a share of performance fees running a fund that is above its high water mark.

The financial crisis that started with a credit crunch in mid-2007 and picked up steam with Lehman Brothers' bankruptcy in September 2008 wreaked havoc on hedge funds, leading about 2,000 funds into liquidation and shaving hundreds of billions of dollars off the industry's assets from fund losses and investor redemptions.

Hedge fund managers who survived are now rebuilding their assets, and saw $13.9 billion in net new money come into the sector in the fourth quarter--the best inflow since the start of 2008. Because of the strong performance gains in 2009, the industry grew to $1.6 trillion at Dec. 31, 2009, from $1.4 trillion at the end of 2008, but is still down from $1.87 trillion at the end of 2007.

Hedge funds are hoping these inflows will continue but they also better hope the markets keep grinding higher. If they don't, many more hedge funds will close their doors in the coming year. It truly is that brutal for hedge funds struggling to deliver alpha in a beta dominated world.

Friday, January 29, 2010

Pensions Look to Leverage Up?

Craig Karmin of the WSJ reports Pensions Look to Leverage Up:

Public pension funds needing to boost their returns but frustrated with hedge funds and private-equity investments are turning to one of the oldest investment strategies—using borrowed money to boost performance.

The strategy calls for leveraging pension funds' safest asset—government or other high-grade bonds—while reducing exposure to stocks.

The State of Wisconsin Investment Board, which manages $78 billion, became among the first to adopt the strategy when it approved the plan Tuesday. The fund will borrow an amount equivalent to 4% of assets this year, and as much as 20% of its assets over the next three years.

Fund officials say that use of leverage could eventually go higher—in theory, at least, up to 100% of assets, according to the staff analysis. But Chief Investment Officer David Villa says that level wouldn't be palatable for the Wisconsin fund. He said the pension fund was advised by four money managers, including Connecticut hedge-fund firms AQR Capital and Bridgewater Associates.

Wilshire Consulting, which advises pension funds on investments, says leverage helps the funds meet their long-term return targets without relying too heavily on volatile stocks, or tying up their money for long stretches in private investments. Low interest rates make it impossible to meet those targets with simple bond investments. Wilshire managing director Steven Foresti says he has been in discussions with about a half-dozen funds that are interested in the leverage strategy.

While public pensions for years have had indirect exposure to borrowed money through property or buyout funds, most have steered clear of borrowing money in their own portfolios.

That public pension funds would contemplate the use of borrowed money so soon after a credit crisis stoked by financial leverage already is setting off alarms for some in the industry.

These analysts wonder if this is little more than the latest gimmick peddled by investment consultants. In previous years, consultants pitched a strategy called portable alpha, an aggressive bet involving leverage and hedge funds that magnified returns when the stock market was surging but aggravated losses when the market turned down.

"When people reach for return with nontraditional approaches they can take on risks they don't fully appreciate," says Daniel Jick, head of HighVista Strategies, a Boston-based firm that manages money for small schools and other investors. As many investors found out in 2008, he added, "using leverage can force you to sell assets you'd rather not sell."

Moreover, he questions the timing of leveraging bonds when many economists are forecasting a pickup in inflation and an increase in interest rates as the economy recovers. That would cause bond prices to fall, and leverage could magnify those declines.

Some advocates of the leveraged approach acknowledge these drawbacks, but say the strategy makes sense anyway. Most big public pensions have expected annual rates of return between 7.5% and 8%. Wisconsin, for example, assumes 7.8%.

Many analysts consider those return rates unrealistic. Yet pension funds are loath to change them because that would require local governments to get more money from taxpayers to compensate for lower projected returns. Even at an 8% return, the average public fund will have about 55% more in liabilities than in assets 15 years from now, due to recent losses and challenges in raising contribution rates, according to PricewaterhouseCoopers.

Most pensions piled into stocks in the late 1990s, counting on a booming market to increase assets, which in turn allowed these funds to increase retirement benefits or reduce state contributions. Since the tech-stock bust, however, many pensions became queasy with the volatility attached to stocks and have been trying to find a substitute to help meet their return targets.

During much of the previous decade, many pensions thought they found the answer in private equity, which put up big numbers. But these funds collapsed in value in 2008 alongside the stock market while locking up pension fund capital for 10 or more years.

"We started talking to the board about this two years ago," says Mr. Villa, Wisconsin's investment chief. "It would have been nice to have this in a place prior to the crisis." That is because the strategy calls for leveraging assets that held value in 2008, Treasurys and other highly rated bonds.

"Fixed income is a good hedge in a crisis scenario," says Rick Dahl, chief investment officer for the Missouri State Employees' Retirement System, who said he is considering using this strategy. "If I can ramp up my fixed income to the point where it gets equity-like returns that makes a lot of sense."

But he isn't yet convinced. "I'll need to think through all the ramifications, too," Mr. Dahl said.

Rick Dahl is one of the smartest pension fund managers I've ever spoken with. While adding leverage to fixed income may sound crazy at this point of the cycle, it might be a worth pursuing, especially if pension funds believe we are heading into a protracted deflationary episode.

The problem with this strategy is what happens when all the pension parrots start doing it? Who is overseeing systemic risk of public pension funds investing in hedge funds, private equity, and now leveraging their fixed income portfolios? I hope someone at the Fed is also "thinking through all ramifications" of this strategy because before you know it, leverage in bonds is about to grow exponentially, posing a new set of macro risks for the global financial system.


The idea of using leverage intelligently can be traced back to Bridgewater Associates:

Engineering Targeted Returns and Risk

The “All Weather" beta strategy suggests that you can maximize your portfolio’s Sharpe ratio (lower risk with higher returns) by leveraging asset classes including bonds. Any asset class that is expected to earn more then the risk free rate, and less then the equity premium. The idea being that by fixing your portfolio for a specific expected return (10% in their article) with leverage you are getting more diversification by having lower asset class correlation, which reduces your portfolio’s risk. In theory it makes sense, but in practice, complications can arise as correlations are notoriously unstable.

Wednesday, January 27, 2010

Private Equity to Gain from New Glass-Steagall?

President Barack Obama's State of the Union address Wednesday is unlikely to translate into dramatic congressional action anytime soon, but it was a phenomenal speech.

The focus was clearly on jobs, which remains the most pressing concern as over 7 million US citizens lost their jobs during this recession. However, President Obama also made it clear that health care reform will remain among his top priority and he urged Congress to finish the job.

One interesting swipe came when President Obama took issue with a recent Supreme Court decision to allow for unlimited campaign donations by corporations (read about the pros & cons of this decision here). The president's comments drew an irate response from Justice Samuel Alito who was obviously one of the judges who voted for this stupid decision.

This brings me to my latest topic, private equity. The Lords of finance were out again, talking up private equity. Jennifer Rossa of the WSJ reports, Apollo's Leon Black Staunchly Defends Buyout Industry:

Leon Black, president and chief executive of Apollo Management, defended Wednesday the private-equity model and the deals done by big buyout shops during the boom years.

"I think it's a pretty good model for an asset class," Black said in a keynote address at the Private Equity Analyst Outlook conference. "I believe in it. I put my own money in it."

Discussing deals done at the top of the boom, he questioned whether Apollo and other firms like it were wrong to pay as much as they did for companies. They were willing to pay more then because the companies for sale were better and because the financing was "incredibly attractive," he said.

"Now you can say these guys overpaid," Black said. "When you look at things at the nadir of the cycle, you're right."

Black agreed that Apollo has made its fair share of mistakes but said that overall he believes the good outweighs the bad by far.

"Apollo has done bad deals in its history," Black said. "Linens N Things was a terrible deal. Having said that, if you look at [the fund that did the deal], we made 21 investments. That portfolio was the best portfolio in our history." He said that fund, Apollo Investment Fund VI LP, has generated a 64% internal rate of return.

Results like this make it easier to have tough conversations with limited partners, Black said. California Public Employees' Retirement System late last year pushed Apollo for more favorable terms, including a lower management fee.

Black didn't directly address the Calpers discussions but said he believes the firm's management fee is already quite low.

"I think we've had a 20-year relationship with our LPs," Black said. "They have every right to complain ... but I do think they believe this is still a very good asset class if you're with a top-quartile performer."

Black also said he believes the opportunity to invest in distressed commercial real estate will be huge and that Apollo will be a player in this area. And he seemed sanguine about the possibility that carried interest taxes may be raised, telling the audience that a higher tax "wouldn't be the worst thing in the world."

Reuters was more specific on where Black sees opportunities in real estate and commodities:

Private equity firm Apollo Management founder Leon Black said on Wednesday he sees investment opportunities in commercial real estate, commodities, metals, energy and agriculture.

He expects to do more distressed investments on a select basis, and sees opportunity for investing in finance-related assets. Black was speaking at a private equity conference in New York sponsored by Dow Jones.

Apollo, which has investments in firms including gaming company Harrah's Entertainment and real estate broker Realogy, has been an active investor in credit and distressed assets.

It said in November it had $13.4 billion of uncalled capital commitments -- or "dry powder" to spend.

Its latest fund, the $14.7 billion Fund VII, started investing in January 2008 in the midst of the economic downturn.

Black conceded that Apollo has done some bad deals, citing Linens 'n Things, a retail investment that filed for bankruptcy protection as sales slumped.

"Linens was a terrible deal but if you look at Fund V, which Linens was in, it was the best (overall) portfolio in our history, and Linens was a wipeout."

Apollo has also been moving closer to following rivals onto the New York Stock Exchange, and in November it updated a regulatory filing regarding its plan. Rival Blackstone Group listed in 2007 and Kohlberg Kravis Roberts & Co, which is listed on Euronext, is expected to move to the NYSE.

Apollo originally filed with the U.S. Securities and Exchange Commission in April 2008 -- before the market slid -- to register securities already traded on a private exchange and said it planned to list them on the NYSE.

Black said on the sidelines of the New York conference that he hopes the shares will be listed by the end of the first quarter, but said the timing was up to the SEC.

Asked whether he expected tax on carried interest to rise -- a controversial debate for private equity -- he said that "when you're dealing with the world of politics nothing is inevitable."

The U.S. House of Representatives has several times voted to increase taxes on carried interest -- compensation earned by hedge fund and private equity fund managers for money management.

These individuals now pay a capital gains tax of 15 percent. The proposal would treat such compensation as income and therefore be taxed at 35 percent.

U.S. President Barack Obama included the proposal in his 2010 budget, though the idea has failed to gain momentum in the U.S. Senate.

"The government is, as it should be, looking for every revenue source," said Black. "It wouldn't be the worst thing in the world for some adjustment," he added.

Others are also selectively betting on commercial real estate. Lavonne Kuykendall reports in the WSJ that Weak Commercial Real Estate Market Hides Deals:
Bonds aren't getting a lot of love lately, as high-profile investors such as Warren Buffett say they favor equities right now.

Bill Bemis, portfolio manager for Aviva Investors, a unit of Aviva USA Corp., manages the group's securitized asset portfolio. He believes there are some great bond deals to be had, particularly in securities backed by commercial mortgages--even as expectations for a downturn in that market grow.

Aviva Investors is a global asset manager whose customers are primarily institutional investors. The group had $362 billion in assets under management at June 30, 2009.

Aviva Investors' fixed income capabilities can be summarized by comparing the net performance of their Core Aggregate portfolio to the Barclays U.S. Aggregate. In the fourth quarter of 2009, Aviva Investors rose 0.77%, compared with the benchmark's 0.2% rise. Over three years, Aviva Investors rose 7.33%, compared to 6.04% for the benchmark.

The minimum investment required for the Core Aggregate portfolio is $25 million. "We expect higher delinquencies, falling property values and lower rents, and commercial mortgage property values will decline in 2010 as well," Bemis said. Market fear over the performance of commercial mortgage bonds is still high, he said, but "that doesn't necessarily mean there is no value in [commercial mortgage-backed securities]."

Even though he said he expects to see the commercial real estate market continue to deteriorate for at least the next year, Bemis said his group is adding exposure to commercial mortgage-backed securities, but only at the highest credit enhancement level, which typically means the triple-A or most protected of the securities.

Bemis buys securities backed by "seasoned" 2005 and earlier mortgages. After that, underwriting on the loans began to deteriorate, he said, just as it did in the residential market, though not to the same degree.

"Our view is that currently you are getting more than compensated for the risks which lie ahead in the commercial real estate market," Bemis said.

Bemis is more bearish on mortgage-backed securities packaged by Fannie Mae (FNM) and Freddie Mac (FRE), the government sponsored enterprises that ran into trouble as the residential mortgage market imploded over the past two years. Bemis expects those securities to underperform in 2010, as the Federal Reserve pulls back on purchasing.

"That is a general theme for 2010," Bemis said. "What happens as the government starts to pull back on some of the stimulus they have put out there?"

For his part, Carlyle Group co-founder David Rubenstein said the private equity industry is still weighing its response to proposals from President Barack Obama’s administration related to limiting banks’ risky bets:
“The private equity industry is not certain what position to take because if we come out in favor, it may not pass, so I’m not sure we should say anything,” said Rubenstein. “I suspect something along those lines will get done in a transition in three to five years so no dramatic affect right away.”

Obama made a proposal this month to limit the size of banks and prohibit them from investing in hedge funds and private equity funds as a way to reduce risk-taking and prevent a repeat of the financial crisis. The plan would also bar banks from running proprietary trading operations solely for their own profit.

Congress may pass some regulatory reforms because of public pressure, though the final outcome remains unclear, Rubenstein said. It is too early to know whether new regulation will be “good or bad” for private equity firms, he said.

Getting national regulatory solutions is “difficult enough,” so getting multilateral solutions are “almost impossible,” he said.

Some think the new reforms will benefit the private equity industry. Jim Kim of Fierce Finance asks, Private equity to gain from new Glass-Steagall?:

Wall Street collectively shuddered at the thought of a new Glass-Steagall. But not all sectors of Wall Street will be affected in the same way. The private equity industry--firms that are not owned by banks anyway--may even gain.

The Financial Times notes data from consulting firm Prequin that shows banks provide only 9 percent of all private equity investments. So the top banks in this arena, mainly Goldman Sachs (GS) and JPMorgan (JPM), do not stand to be affected in the main.

The wider industry may also welcome the changes. If a bank ends its private equity investment business, "it will no longer get first look at deals the investment bank is working on. Smaller fund managers will welcome the level playing field."

At the same time, if a target goes bankrupt, will the bank be able to assume ownership? It's unclear. If a bank will not be able to hold principal investments, that line of assumed protection goes away. Costs may rise, but that may not be the case. There may be a fine distinction.

Let me end by stating that my favorite part of President Obama's speech was how he ended by talking about the growing cynicism gripping Americans. He made reference to the "resilience" and "values" that helped shape America. He also noted, in the past, politicians didn't sign bills for the next election, but for the next generation. Let's hope this wasn't empty rhetoric and that both he and Congress will pass meaningful reforms.

Tuesday, January 26, 2010

Get Ready for More Upward Growth Revisions?

Before I get into the latest topic, one small reminder on Haiti. It has been two weeks since that devastating earthquake and relief is only now starting to be more readily available.

But for some victims, relief will be much harder to get. I listened to Heather Mills of Physicians for Peace speaking to CNN's Larry King about the disabled in Haiti. I also read an article in the Globe and Mail, Program for the disabled lost in Haiti's rubble. It says that despite the odds, Canadian Marika MacRae, head of the charity Pazapa, insists the organization will carry on. Pazapa is a charity that has served disabled Haitian children since 1987 was wiped out in the earthquake.

Being disabled is hard enough in the developed world, I can't imagine how horrible it must be in a Third World country like Haiti that has just been devastated by a massive earthquake. Thank God organizations like these exist.

Anyways, back to pensions and financial markets. The big news on Tuesday was that the International Monetary Fund (IMF) revised up its global growth forecast to near 4% in 2010:
The global economy, battered by two years of crisis, is recovering faster than previously anticipated, with world growth bouncing back from negative territory in 2009 to a forecast 3.9 percent this year and 4.3 percent in 2011, the International Monetary Fund said in its latest forecast.

But the recovery is proceeding at different speeds around the world, with emerging markets, led by Asia relatively vigorous, but advanced economies remaining sluggish and still dependent on government stimulus measures, the IMF said in an update to its World Economic Outlook, published on January 26.

“For the moment, the recovery is very much based on policy decisions and policy actions. The question is when does private demand come and take over. Right now it’s ok, but a year down the line, it will be a big question,” said IMF Chief Economist Olivier Blanchard in an IMF video interview.

IMF Managing Director Dominique Strauss-Kahn has warned that countries risk a return to recession if anti-crisis measures are withdrawn too soon.

The IMF said it had revised upwards its earlier forecast for global growth by ¾ percentage point from the October 2009 forecast.

Risk appetite returning

Along with the update to its forecast, the IMF also released a new assessment of global financial conditions in its Global Financial Stability Report (GFSR). It said that financial markets have rebounded since the lows of last March, the result of improving economic conditions and wide-ranging policy actions by governments.

“Notwithstanding the recent sell-off, risk appetite has returned, equity markets have improved, and capital markets have reopened,” Jose Viñals, Director of the IMF’s Monetary and Capital Markets Department, said.

But policymakers still face extraordinary challenges as they seek to unwind the unprecedented fiscal, monetary, and financial support they provided to keep their economies and financial markets from collapsing, the GFSR update pointed out.

Strength of U.S. consumption

The WEO forecast said that in advanced economies, the beginning of a rebuilding of corporate inventories and the unexpected strength of U.S. consumption had contributed to a rebound in confidence, and inflation was expected to remain contained. But high unemployment rates, rising public debt, and, in some countries, weak household balance sheets present further challenges to the recovery.

The IMF report said that the varying pace of recovery across countries called for a differentiated response in the unwinding of measures used to stimulated the economy and combat the crisis.

Due to the still-fragile nature of the recovery, fiscal policies need to remain supportive of economic activity in the near term, and the fiscal stimulus planned for 2010 should be implemented fully. However, given growing concerns about fiscal sustainability, countries should also make progress in devising and communicating exit strategies.

Financial sector repair

Crucially, there remains a pressing need to continue repairing the financial sector in advanced and hardest-hit emerging economies. In these cases, policies are still needed to tackle bank’s impaired assets and restructuring. Unwinding the financial sector support measures gradual; it can be facilitated by incentives that make measures less attractive as conditions improve.

Policymakers will also need to move boldly to reform the financial sector with the objectives of reducing the risks of future instability and rethinking how the potential fallout of financial crises would be borne in the future, while at the same time making the sector more effective and resilient.

At the same time, some emerging market countries will have to design policies to manage a surge of capital inflows. Macro-prudential policies can be used to address the potential for bubbles at an early stage by limiting a buildup in risks.

(Click on image to enlarge)

As you can see, the most significant revisions from October were in newly industrialized Asian countries, led by China, but significant upward revisions also came from the US and Canada.

What did the stock market do? It rallied following a better than expected consumer confidence report but then fizzled this afternoon. The five day chart of the Dow Jones says it all:

But as growth comes in stronger than expected, it will be interesting to see if markets will respond in kind. If not, this could signal that growth will peter out in the second half of the year.

One report that has been making its way around the investment community recently comes from McKinsey Global Institute (MGI), Debt and deleveraging: The global credit bubble and its economic consequences. It's a fascinating (and scary) read of a long-term structural debt problem that could take years to work through. It's scary because the report neglected to focus on the global pension crisis, which will add to the deleveraging process.

All this is in the future. But for now, get ready for more upward revisions and pay close attention to any speculative activity bubbling up in the stock, bond, and commodity markets. Oh, and before I forget, don't you worry, Bubble Ben will get reappointed on Thursday. He's a shoo-in.

Monday, January 25, 2010

New Focus at the Caisse?

CBC reports that Sabia lays out Caisse turnaround plan:

The head of Quebec's public pension fund vowed a return to "plain old common sense" in its investments Monday as it tries to come back from an underwhelming investment performance.

Michael Sabia, who has been president and CEO of the Caisse de dépôt et placement du Québec since last March, set out a list of priorities the fund aims to meet in the next 18 months.

In a letter published Monday on the Caisse's website, Sabia said he wanted to provide Quebecers with a progress update on his plans to revamp the Caisse's operations and improve its financial results.

"The Caisse has just lived through the most difficult time in its history," Sabia wrote. "The economic and financial environment has changed radically. As a result, we have had to make important changes."

Sabia, previously chief executive at BCE Inc., said the Caisse will now invest only in financial instruments that it understands and has mastered. In recent years, the pension fund lost billions on asset-backed commercial paper and other securities that turned out to be riskier than expected.

The Caisse reported a $40-billion loss in 2008, a drop of 25 per cent in the value of its assets to $120.1 billion. That compared with an average return of minus 18 per cent for its rivals during the same timeframe.

Sabia said the Caisse needs solid financial foundations that can weather market turbulence, and it has doubled its liquidity and reduced its financial exposures.

"Some basic principles have guided our work. They are based on the value of `plain old common sense' — simplicity, rigour, performance and a focus on the client," he wrote. "It is on the basis of these principles that we are building solid foundations for our long-term success."

In August, the Caisse announced it would revamp its real estate arm and abandon risky commercial loans after $5.7 billion in losses wiped out other gains during the first half of 2009.

Official data for the full year has yet to be released, but an association representing public-sector retirees has sounded the alarm over the Caisse's performance in the first 11 months of 2009, saying it compares poorly with other Canadian pension funds.

Slack 2009 return

In a recent letter published on the website of the Association Québécoise des retraité(e)s des secteurs public et parapublic, the group said it has obtained a document that indicates the Caisse will have a total return of six to seven per cent on funds it managed in 2009.

"Once again this year, it would seem the Caisse will not do as well as others," the letter said.

The Caisse has drawn fire for sitting on the sidelines during the stock market rebound which has driven the benchmark TSX index up by roughly 50 per cent from its trough in March. The Caisse did not hire a new chief investment officer until July, months after the market revival had begun.

"The Caisse was underweight in stocks, and given that stock markets have rebounded considerably, the Caisse's results will certainly not exceed those of competing pension funds or industry peers," Quebec Finance Minister Raymond Bachand acknowledged in November.

Sabia's letter downplays those concerns, saying the Caisse has rebalanced its investment portfolio by progressively buying $9 billion in equities.

And instead of withholding results until the end of the fiscal year as it currently does, from now on the Caisse will issue an overview of its investment returns at mid-year, Sabia said.

Mr. Sabia has his work cut out for him as his clients remain skeptical of the Caisse's new focus:

An association representing retired public employees has complained about the returns generated by the Caisse for the first 11 months of 2009, saying they compare poorly with other forecasted returns from other Canadian pension funds.

Association president Madeleine Michaud said she's not entirely satisfied with Sabia's public declaration.

"We are still skeptical about the change in direction for the Caisse," said Michaud of the Association quebecoise des retraites des secteurs public et parapublic based in Quebec City.

As for Sabia's pledge to return to the basics, Michaud also questioned why it's being stressed at this time.

"Plain old common sense, it still has its place. But why is it being done now?" she asked.

"Yes, the intentions are good, yes it's interesting. But will it really translate to concrete, good, satisfactory results. I doubt it because we don't know what happened."

Michaud said she would like some representation from her association on the Caisse's board and a full public inquiry into how the Caisse lost $40 billion in 2008.

A recent letter published on the association's website expressed concern about the Caisse's expected returns.

The group said it obtained a document under access to information laws that indicates the Caisse will have a total return of six to seven per cent on funds it managed in 2009.

"Once again this year, it would seem the Caisse will not do as well as others (pension managers)," the letter said.

Like other fund managers, the Caisse was hurt by the global financial crisis, though it took the biggest hit from the collapse of Canada's market for third-party asset-backed commercial paper in August 2007.

It remains to be seen how well the Caisse did relative to its peers in 2009, but it's unlikely to have performed as well. The Toronto Sun reports that pensions claw back to pre-crisis levels:

Canadian pension plans recouped most of their recession-time losses last year, according to a new RBC Dexia Investor Services study.

Improving global equity markets helped boost pension assets in the fourth quarter, the survey released Thursday found.

Pension plans in this country earned 1.9% in the final three months of the year, bringing year-end results to 16.2%.

“The speed of the rally, particularly in the second and third quarters caught pensions by surprise, as many remained under-exposed to equities," said Don McDougall, director of Advisory Services for RBC Dexia.

"Then again, after last year's brutal 15.9 % drop, it is reassuring to see pension plans claw back to a pre-crisis state."

Helping matters was the S&P/TSX Composite Index’s outstanding performance in 2009. The index posted its best gains in three decades last year, soaring 35.1%.

Foreign markets also made a comeback last year, lifting world indexes 25.7%.

"Unfortunately for unhedged Canadian-based pensions, a stronger loonie against most world currencies slashed the foreign equity returns to 12.6%,” McDougall said.

Domestic bonds also outperformed the DEX Universe index by 2.5%, paving the way for a 7.9% advance in Canadian pensions.

RBC Dexia Investor Services offers a range of investor products including Canadian pension funds. The company, equally owned by RBC and Dexia, manages $2.3 trillion US in client assets worldwide.

I doubt any pension plan clawed back to pre-crisis levels (do the math), but it's certainly true that the sharp rally in global equities provided much needed relief to pension plans that were reeling after suffering devastating losses in 2008.

As for the new focus at the Caisse, I went over Mr. Sabia's open letter and honed in on the fourth and fifth priorities:

And we will continue improving our risk management capabilities: our fourth priority. To be clear: risk management is not about avoiding risks — risk is an inherent part of investing. Instead, we believe risk management is about understanding the risks we take and chosing them with judgment and precision. When we can do that, we can take and manage the risks that are necessary to generate the returns expected by our depositors over the long haul.

Our fifth priority: changing the culture of the Caisse — changing how we work. While this starts with understanding the needs of the client, it touches many other things: having our portfolio managers balance returns and risks in all their decisions; putting an emphasis on collaboration and teamwork; setting high standards; and perhaps most important, understanding that our expertise is at the service of our depositors and of Québec.

Risk management is about understanding all risks, including investment, operational, legal and reputation risks. It's funny how it took a crisis to refocus on risk management when the reality is that pension funds should be taking more risk at the market bottom and playing closer attention to it when everyone seems to be shooting the lights out.

As for changing the culture at the Caisse, it will never happen as long as the same individuals are running certain departments (leadership risk). Piecemeal changes won't cut it; the Caisse needs wholesale changes and a lot more diversity. People need to come into work every single day with one and only one thing on their minds: how are we going to work as a team and make money?

The rest is just bullshit. Trust me, I've been around long enough and seen how a few ruthless egos can destroy the culture at these large pension funds. And if anyone tells you otherwise, they're lying to your face.

[Hint: Is information being properly shared among private and public markets? What about information from external hedge fund/ private market managers and private research outfits? Is that being properly shared with investment staff to prepare for the challenges ahead? If not, there is a serious gap.]

Sunday, January 24, 2010

Pensions Pouring Money Into EM Debt

Steve Johnson of the Financial Times report that pensions pour into emerging market debt:

US pension funds are poised to pour almost $100bn (£62bn, €70bn) into emerging market debt in the next five years, according to JPMorgan.

The impending buying spree will be augmented by strong flows from central banks desperate to diversify out of the dollar, industry figures believe, bolstering the ongoing rally in emerging market bonds and potentially pushing yields relative to US Treasuries to a record low.

“We expect a long-term structural bid [from US pension funds] for emerging market debt,” said Will Oswald, global head of emerging market quantitative strategy at JPMorgan.

Jerome Booth, head of research at Ashmore Investment Management, an EM debt specialist, said: “Pension fund consultants are being inundated with requests.”

Demand is being driven by the 2006 Pension Protection Act, which came into force in 2008 and compels US corporate pension funds to discount their future liabilities using a market interest rate, rather than using their expected rate of return on their assets, as public sector funds can.

This is pushing corporate funds to sell equities and buy bonds, as they seek assets whose value moves in line with the new discount rate. In the 10 months to August 2009, US corporate pension funds increased their allocation to bonds from 32.4 to 38.4 per cent, according to Towers Watson, with further buying expected this year.

JPMorgan said there were signs much of this would go into emerging market debt as pension funds sought the higher yields and longer duration of the EM universe, where 30-year bonds are commonplace, allowing pension funds to hedge liabilities more accurately.

Inflows are likely to be bolstered further by the benchmark sovereign bond index, JPMorgan Embi Global Diversified, attaining investment grade status earlier this month.

According to JPMorgan, corporate US pension funds currently have just 0.3 per cent of their assets in EM debt. However, funds that have rebalanced have typically moved to a 5-7 per cent allocation, a figure Mr Oswald argued was “realistic” across the whole sector within three to five years.

With corporate US schemes holding $1,400bn of assets, this implies $90bn of fresh investment, a significant sum compared to the $300bn currently benchmarked against the JPMorgan indices.

Mr Booth added: “The Pension Protection Act is motivating a lot of corporate plans in the US. They can increase their duration by a year and their yield by 130 basis points by putting more money into EM debt. And the index becoming investment grade means it will be seen as much more investable by a wide range of institutions.”

Robin Creswell, managing principal of Payden & Rygel Global, saw potential for “substantial demand” from pension funds, as a result of improving economic fundamentals across emerging markets and the fact that yield spreads are above 2007 levels, despite EM debt being investment grade.

EM debt is also receiving a shot in the arm from Asian central bank reserve diversification and petrodollar recycling, according to Mr Oswald. “We continue to get enquiries from central banks.”

Mr Oswald saw the potential for a bubble to emerge, but Mr Booth argued supply would rise to meet demand and that yields on local currency EM debt had the potential to fall to below those of US Treasuries.

Friday, January 22, 2010

Awakening Japan's Sleeping Giant?

Chikafumi Hodo of Reuters reports that Japan's public pension fund urged to seek higher returns:

A Japanese government minister on Friday urged the country's massive public pension fund to seek higher returns, ramping up pressure on the traditionally conservative investment portfolio to take more risk.

The size of the $1.36 trillion public pension fund, the world's largest, is greater than the 2008 gross domestic products of countries including Australia, India and Mexico, and is almost seven times bigger than top U.S. pension fund CalPERS.

Internal Affairs Minister Kazuhiro Haraguchi told reporters at a news conference after a health ministry panel meeting that the Government Pension Investment Fund (GPIF) should seek greater returns than it has generated in the last few years.

He urged a review of the fund's performance after the rate of return on its investments fell to minus 10.3 percent, or a record loss of 9.7 trillion yen ($108 billion), in the financial year that ended in March 2009.

The GPIF has boasted that its conservative strategy, under which nearly 70 percent of its assets are held in Japanese government bonds, helped limit its losses compared to foreign pension funds that year.

Haraguchi declined to comment on how the GPIF should set up its portfolio, however, as his views could impact markets.

The internal minister also said there should be a review of whether it is appropriate for a lone person, the GPIF president, to give the final approval for the fund's asset allocation and also whether a single body should manage such an enormous fund.

"We need to verify whether it is appropriate for only one organisation to manage such a huge fund of more than 120 trillion yen," Haraguchi said.

But Health Minister Akira Nagatsuma, who supervises the fund, said it should stick to safe investments.

Nagatsuma said in a speech at the meeting that the U.S. public pension fund is even more conservative than the GPIF as it only invests in Treasury bonds.

Haraguchi's internal affairs ministry oversees the country's independent administrative institutions, or semi-government agencies, such as the GPIF.


The GPIF manages its fund in line with a model portfolio, which is reviewed every five years based on a return target given by the health ministry.

The health ministry panel is currently drawing up a new investment target, which is scheduled to be given to the public fund in February or March, a health ministry official said.

The GPIF is set to manage their funds under the new model portfolio from April.

Domestic bonds currently make up 67 percent of the public fund's portfolio, domestic stocks comprise 11 percent, foreign stocks 9 percent and foreign bonds 8 percent.

Analysts said the GPIF's portfolio is too big for a drastic allocation change, but that there is a need for the public fund to be more transparent.

The current procedure for determining asset allocation involves both the health ministry and the GPIF, making it difficult to pinpoint who is responsible for its performance, analysts said.

"Its portfolio is so enormous that any changes in its investment strategy could move markets, so it is understandable that there is an argument for restructuring," said Takahiro Tsuchiya, a strategist at the Daiwa Institute of Research.

"But whether such a move is possible is open to question as it would cost a lot," Tsuchiya continued.

My advice to Japanese authorities is to break up this giant fund and set up a more diversified asset allocation with tight governance rules that limit the downside risk. If you invest in hedge funds, set up managed accounts where you can pull the plug at any time. There are a few knowledgeable advisors you can work with to set this up. If you diversify into private equity and real estate, be careful and once again, choose your partners wisely.

What will an asset allocation move from Japan's sleeping giant mean for the markets? Probably nothing in the near term, but over the longer term, this will add to the liquidity tsunami and direct investments into stocks, hedge funds, private equity funds can potentially impact markets in a profound way.

Thursday, January 21, 2010

Public Pensions Falsifying Investment Returns?

Stocks tumbled on Thursday as President Obama took on the banks:

Mohamed El-Erian, chief executive of Pimco, told the Financial Times: “Today’s announcement is part of the broader phenomenon of de-risking banks, and moving the sector more towards the ‘utilities’ end of the operating spectrum.

“This reflects post-crisis governments reaction to both systemic risk and political realities. It comes at a time of increasing structural inconsistencies in advanced economies, including the conflict between the de-risking banks and expecting them to lend more to the struggling real economy.

“After a liquidity and stimulus driven rally, stocks are starting to reflect the realities of structural imbalances in both the economy and the policy responses.”

The Dow Jones was down 213 points, its fourth consecutive day of triple-digit moves. The volatility saw the Vix index, known as Wall Street’s fear gauge, jump 19.2 per cent to move back above 22.

Investors rushed into the perceived haven of government bonds. The yield on 10-year US benchmark Treasuries reversed an early rise to drop 5 basis points to 3.59 per cent, with a worse than expected US weekly initial claims number and a disappointingly soft Philly Fed business survey providing further support.

The dollar initially lurched higher to fresh 15-month peaks as the President’s plans were revealed. However, it swiftly fell back into losses as traders baulked at the belligerent tone of Mr Obama’s remarks and the impact his proposals may have on US financial sector competitiveness. The buck was 0.1 stronger at $1.4091 versus the euro but fell 0.9 per cent to Y90.41 against the yen.

With all due respect to Mohamed El-Erian, if he thinks today's action reflects the "de-risking" of banks, then he's sorely mistaken. President Obama can huff & puff all he wants publicly, but privately he knows he's going to have a hard time passing a fraction of those proposals.

This is just political smoke because as was mentioned by someone on the Zero Hedge blog, Big Banks Have Already Figured Out The Loophole In Obama’s New Rules. But the bears are growling now, led by guys like Bob Prechter, who is convinced the bear market is back.

I remain optimistic that equities will grind higher and will accumulate more shares (in specific sectors like tech and solar) from now until the next US employment report.The best line I heard on Thursday came from Warren Buffett who stated on Fox news that bank failures should destroy CEOs:

“There ought to be a huge downside,” said Buffett, whose Berkshire Hathaway Inc. is the largest shareholder in Wells Fargo & Co. “Make it so that the CEO of an institution that fails, or goes to the government and needs help, really gets destroyed himself financially. Why should he come out any better than somebody that gets laid off as an auto worker at General Motors?”

Buffett, who collects a $100,000 salary as Omaha, Nebraska- based Berkshire’s leader, said CEOs must act as the “chief risk officer” of their companies. He has repeatedly criticized bankers for failing to realize that housing prices could fall and said they exacerbated their mistakes by borrowing to increase the size of their failed bets.

“I think you have to change the incentives,” Buffett said on the cable news channel. “It’s nice to have carrots but you need sticks. The idea that some guy is worth $500 million and leaves and only has $50 million, that’s not much of a stick. There ought to be a huge downside.”

You certainly need more sticks. Soros talked about alignment of interests and that's exactly what Buffett is hinting at. These banking "prima donnas" have no skin in the game. All upside, hardly any downside. No wonder they take reckless risks to maximize profits.

And if you think bankers' incentives are bad, let me introduce you to Canadian public pension fund managers. They too have no skin in the game and if the shit hits the fan, like it did in 2008, they just fall back on their four-year rolling returns to collect multi-million bonuses.

One senior vice-president in private equity once told me "it's a great gig". It sure is, especially if you have incompetent board of directors who do not know how to properly compensate pension fund managers using benchmarks that accurately reflect the risk being taken.

As if that's not bad enough, I was skimming through some articles on Jack Dean's Pension Tsunami, and noticed an article in Forbes from Edward Siedle, Public Pensions, Managers Falsify Investment Returns:

The Ohio Bureau of Workers' Compensation fund provides coverage for workplace injuries to two-thirds of its state's workforce and has $22 billion in funds to back it up. In April 2005 this then little-known organization reported investment returns that seemingly made it a star of the financial world--16.5% per year in a decade when the S&P 500 had earned only 10.6% annually.

Later that year, however, those returns came under suspicion when the BWC burst into the headlines as the focus of a massive investment fraud. It involved unconventional investments that had been managed by people closely connected to financial backers of the Ohio Republican Party. Have you ever heard of a state investment fund investing in gold coins or Beanie Babies? This one did.

Upon further review, it turned out that the BWC's reported investment returns were fictitious. "We are unable to establish any basis whatsoever for the 16.5% figure," an outside performance review concluded. The fund had actually earned 7.3% annually--less than half of what it had previously claimed.

In other words, the largest state-operated workers comp fund in the country had massively misrepresented its performance. Subsequent revelations showed that sloppy mathematical calculations weren't the problem. There had been a deliberate, concerted effort involving BWC's investment staff and vendors to inflate the performance.

If a Securities and Exchange Commission-registered money manager had committed similar fraud, it would have been shut down. But governmental investment funds, including hundreds of public pension plans, are generally not subject to SEC regulation.

This brings into question not only their overall performance claims but also those of the outside managers they hire. Given that such outsiders are often paid based on the returns they report, and thus have a huge incentive to cook the books, I suspect that many of the numbers issued by public pension funds are wrong. What's more, in my experience, many public funds fail to submit their reported rates of return to the sorts of audits and verification money managers in the private sector regard as mandatory. It's just too politically fraught. I call this politicization of the investment process.

For a look at just how averse outsiders can be to reporting bad numbers, see the Alaska Retirement Management Board. In 2007 the state agency filed suit against Mercer, a unit of Marsh & McLennan ( MMC). Mercer, the agency contends, made multiple errors as the state's actuarial consultant when it estimated the amounts that two of the state's retirement plans needed to set aside for health care and pension benefits. The agency is seeking damages of $2.8 billion. Now it seems the financial health of these systems is far different from what investors were told, perhaps dire. Liabilities were grossly understated. Again, if an SEC-registered money manager had committed these errors, they'd be held accountable.

This article highlights the need for external performance audits conducted by independent industry experts. It's not just about benchmarks; it's also about making sure the investment returns reported by internal and external managers are being reported accurately, verified internally by the finance department, and by external, independent experts to see if they pass the highest industry standards.

And annual financial audits are simply not enough. Accounting firms are notorious for letting things go and they are not trained experts in hedge funds or private equity funds so they will not know what to look for. Moreover, there are potential conflicts of interests since accounting firms want future business from the public pension funds they're auditing and will not dare piss off their senior managers.

The more I think about it, the more I like Buffett's idea. Let's go after the personal assets of Canadian public pension fund managers who invested in ABCP, shady real estate, private equity and hedge fund investments. If they lose billions, they should feel the pain too.

Wednesday, January 20, 2010

Is Private Equity Staging a Comeback?

Before I delve into the latest topic, I received an important message from Ellie Brown of International Medical Corps:
Dear Leo,

International Medical Corps is a global, humanitarian, nonprofit organization, founded by volunteer doctors and nurses and dedicated to saving lives and relieving suffering through relief and development programs. Our emergency response team is in Haiti responding in force and I would like to ask for your help to get the word out to the readers of Pension Pulse.

There are still thousands of patients seeking treatment of which approximately 80% are in need of surgery and are running out of time - especially with the tremendous aftershocks still devastating this country.

The team is treating crush injuries, trauma, substantial wound care, shock and other critical cases with the few available supplies - And they're in it for the long haul. I would love your help spreading the word by blogging or tweeting about IMC's rescue efforts. We've put up a blogger friendly widget here on our site:

With the widget it's really easy to let your readers know that donating $10 to help the people of Haiti is as simple as sending a text message of the word "haiti" to 85944. If you have any questions just let me know and I will do my best to help you out. If you are able to post the widget or tweet, I would appreciate it if you could send me the link.

Thanks so much,


Ellie Brown
International Medical Corps

Please give whatever you can to this wonderful organization. I am going to post the widget on my blog as soon as I can, but please visit their site and see the great work they're doing.

Now, back to pensions. On Tuesday, Reuters reported that Ontario Teachers to acquire UK education provider:
One of Canada's largest pension administrators, the Ontario Teachers' Pension Plan, has agreed to buy a leading British provider of special needs education, for an undisclosed sum.

The private equity arm of Teachers, a pension plan with over C$87 billion ($84 billion) in net assets, agreed to buy Acorn Care and Education Ltd from British mid-market private equity firm Phoenix Equity Partners, the UK firm said in a statement.

Terms of the deal were not disclosed, but a report in Britain's Financial Times pegged its value at about $245 million. Teachers could not be reached for immediate comment.

The Canadian private equity industry, a global leader, is homing in on acquisition opportunities at home and abroad in the wake of the global financial crisis.

Experts say dealmaking in the private equity space will likely grow in 2010 as the spread between bid and asking prices narrows and targets come up for sale, with deep-pocketed pension funds like Teachers leading the way.

Acorn, which provides facilities for children with special needs, operates 10 schools across England and has grown through acquisition from just two schools in 2005.

It put itself up for sale in late 2009.

Teachers invests and administers the pensions of 284,000 active and retired teachers in Ontario and is one of Canada's largest investors.

The fund's private equity arm, which manages around C$10 billion and owns companies across the globe, has been actively seeking growth.

Its director, Erol Uzumeri, has in the past described the current investment climate as "the best investment opportunity of my lifetime."

Teachers announced plans in early January to buy AIG Inc's Canadian mortgage insurance business, with assets of C$274 million.

Reuters did report that Canadian private equity deals seen jumping in 2010:

Infrastructure renewal, government stimulus spending and the end of the traditional income trusts will drive Canadian private equity deals higher in 2010, according to a top industry player.

Gregory Smith, the president of the Canadian Venture Capital and Private Equity Association (CVCA), told Reuters that buyout firms could participate in as many as 30 percent more deals this year than last, helped in part by narrowing spreads between the buy and sell on potential deals.

"I think you'll see investment activity improve, enhanced investment activity," Smith said weeks ahead of the official release of CVCA figures for 2009 and for its 2010 outlook.

"The difference between January 2010 and January 2009 is that in January 2010 people actually have a view. People this year are prepared to make commitments based on their outlook."

There were some 100 deals done by private equity firms in 2009, slightly more than in 2008 but well below peak deal volume of 140 before the global economic crisis.

Canadian income trusts lose their favored tax status 2011, forcing them to reassess strategies from ones aimed at giving investors regular cash payments to ones focused on increasing production and growth.

Larger trusts, many of them oil and gas companies in Western Canada, will mostly opt to become corporations, but smaller companies in sectors like manufacturing and food distribution will have to seek other options.

"You probably need a market cap of C$500 million ($487 million) to effectively get the attention of investors and analysts and have sufficient liquidity," said Smith, who estimated 50 to 100 companies could fall into that category.

"Less than that and PE (private equity) provides a compelling alternative," he said.

Canada needs about C$200 billion to replace aging infrastructure, from schools and bridges to water and waste water facilities, and for electricity generation.

Smith said investments related to revamping infrastructure, and stimulus spending announced by the government during the recession, will form the focus of private equity buyout activity this year.

He pointed at recent financing activity in public markets as a sign of a strong market for fund-raising in 2010.

Onex Corp, one of Canada's best-known buyout companies, said early this month it boosted its stake in a new fund by 60 percent due to optimism about near-term investment opportunities.

Toronto-based Onex, with stakes in sectors as diverse as electronics, health care, cosmetics and movie theaters, said it would boost its stake in Onex Partners III to $800 million from $500 million, bringing the total fund size to $4.3 billion.

"That is indicative of how fundraising will come back in 2010," Smith said.

Smith said the outlook for venture capital was poor, predicting investment in the already struggling sector could plunge 30 percent in 2010, for another dismal year.

He predicted venture capital activity would be worth about C$1 billion in 2009, 30 percent less than in 2008, when it also had a poor showing.

Venture capital is risky in the best of times, so you can imagine how bad it is during these challenging times when banks are unwilling to lend past three year terms. But private equity is staging somewhat of a comeback, and it couldn't come soon enough.

Marietta Cauchi of Dow Jones Newswires reports that in the UK, buyouts hit a 25-year low as debt dries up:

The value of buyouts fell 72% in 2009 to hit a 25-year low as debt to fund deals remained elusive and sellers refused to drop prices, according to research released Tuesday.

Deal value was just GBP5.5 billion last year, compared with GBP19.7 billion in 2008 --a level not seen since 1995, said the Centre for Management Buyout Research, or CMBOR.

Meanwhile the volume and value of private equity-backed buyouts at 117 deals and GBP4.7 billion respectively were also the worst for a quarter of a century.

"Overall the end of this decade has seen very low levels of buyout activity compared to a far more buoyant private equity market in 2006-2007," said Christiian Marriott, Director at Barclays Private Equity which sponsors the research.

"In addition, of the total recorded deal value of GBP4.7 billion in 2009, GBP1.2 billion is related to one transaction--the buyout of NDS Group," he added. The U.K. digital pay-TV company was taken private by Permira in a transaction that left the private-equity firm with a 51% stake in the digital pay TV specialist. News Corp. (NWSA), which owns Dow Jones, the publisher of this newswire, holds the remaining 49%.

Large buyouts which require higher multiples of debt were the hardest hit and private equity buyers were forced to stump up significantly higher amounts of cash to fund acquisitions--the average equity contribution rose to 64% in 2009, from 48%, said CMBOR.

However there is evidence that confidence is returning to the buyout market as the value of buyouts backed by private equity firms in the fourth-quarter of 2009 rose 48% to GBP843 million, from GBP636 million the previous quarter, it added.

Further, confidence is also returning to public markets and a slew of initial public offerings by private equity-owned companies are coming to market including Blackstone Group's (BX) Travelport which earlier Tuesday confirmed plans to float its shares on the London Stock Exchange in a transaction valuing it at around $3 billion, London's largest IPO in nearly two years.

Finally, Steven Davidoff of the NYT's Dealbook reports on the evolving IPO market, circa 2010. Read this article carefully and note the conclusion:

Ultimately, while there are reasons for optimism, the numbers appear to show that the market for initial offerings is in transition. It would behoove market participants and regulators to take a hard look at market structure again, including these important issues, through a lens other than Sarbanes-Oxley.

I am very cautious on private equity and other private market assets like real estate and infrastructure. Given the macroeconomic uncertainty, I think pension funds should think long and hard before committing capital to private assets.

Ultimately, what matters most is whether or not we're heading into a protracted inflationary cycle or deflationary episode. If it's the latter, private markets are cooked.

Tuesday, January 19, 2010

All-Out War on Pensions Brewing in Canada?

A follow-up to yesterday's comment on the $58 billion debt time bomb. On Tuesday, Kathryn May of the Ottawa Citizen reports federal PS unions gird for battle over pensions:

OTTAWA — Canada’s 18 federal unions are meeting in Ottawa for two days starting today to develop a united front against what they believe is the Harper government’s gathering assault on the public service.

Facing one of the largest deficits in Canadian history, union leaders are braced for Finance Minister Jim Flaherty to turn to the public service to balance his books.

One of the major concerns is persistent rumblings about cuts to the public service’s generous pensions and benefits.

“We don’t know where they will be coming at us … but we want to have common footing, so it in our best interest have common positions we can take,” said John Gordon, president of the Public Service Alliance of Canada.

Gordon says the Conservatives have long grumbled about public service pensions back to Prime Minister Stephen Harper’s days at the National Citizen’s Coalition. The government has said it won’t cut transfers to the provinces or raise taxes, but will rely on economic growth and government spending cuts to eliminate the deficit.

“This isn’t new, but given the economy and what’s happened in the private sector, everyone has turned their sights on the provincial and federal plans. They will all come under the microscope,” Gordon said.

Flaherty has said the “handsome arrangements” of all public servants came up at a recent federal-provincial meeting in Whitehorse on pension reform.

But union leaders say the government should be prepared for an all-out war with its employees if it tampers with their defined benefit pension plan or tries to convert it to a defined contribution plan as has happened in Britain.

Ron Cochrane, co-chair of the National Joint Council, which represents public service management and unions, said “nothing would galvanize even the most apathetic public servant like touching their pension.”

“When you attack people’s retirement savings, you are asking for the fight of your life and I think it would be a most unwise thing for any political party to do. And if they did it to public servants, they would have to do it to the military and RCMP, and do they really want to annoy them?” said Cochrane.

And the unions will be the first to pounce on MPs, judges and deputy ministers whose pensions are even richer than those of the rest of the public service.

The most talked about solution for the government to reduce the pension costs of its employees is to make public servants — who now make about 32 per cent of the contributions to the plan — pick up half the share of the cost.

Federal employees paid $1.2 billion in contributions into the plan in 2007-2008 while the government kicked in $2.6 billion.

The federal government has long contributed more to the pension plan than public servants, but that gap has narrowed over the years. By 2013, the government will kick in about 60 per cent of the contributions while public servants pay about 40 per cent.

Contributions to public service pension plans are shared 50-50 in Ontario, Quebec and Alberta so many argue there’s no reason federal workers can’t fully pay their way.

The federal plan’s early retirement provision is another rumoured target. This allows public servants to retire with a full pension at 55 as long as they have served 30 years. The government has also explored the idea of phased retirement, allowing bureaucrats to work and collect their pensions. Unions have strongly opposed this unless the option was open to all workers and not just those chosen by management.

Gary Corbett, president of the Professional Institute of the Public Service of Canada, said the pressure to take aim at federal pensions started with the C.D. Howe Institute, which released a report that has concluded the plans of Canada’s bureaucrats, military and RCMP were going to cost billions more than expected. He said the report is being seized as justification to reduce public sector pensions rather than improving pensions in the private sector.

“The attitude is that public servants should be getting pensions like that rather than making sure everyone in the private sector has a better plan. They would rather level down the good plan rather than make the other ones better.”

Unions say that whenever the economy sags, the private sector complains about the rich salaries, pensions and benefits of public servants.

The bureaucracy is a prime target for cuts because the number of people on payroll grew more than 40 per cent over the last 12 years — with a major hiring spree since the Conservatives took over.

Secure and generous pensions were historically considered key to protecting the public service from corruption. Also, many public servants aren’t as free as private sector workers to invest in the market because of potential conflicts of interest on policy issues they are working on.

I don't buy the argument that generous pensions are the "key to protecting the public service from corruption". But unions are right to be on guard because as George Carlin says at the bottom of my blog, on the American Dream, "they're coming after your retirement money...they want it all back!"

One union representative shared these comments with me:

Thank-you very much for your most recent comments on Ottawa Citizen journalist Kathryn May's article on the recent C.D. Howe Institute report on Federal Public Service Pension Plans. My office had been receiving several telephone calls from Ms. May in advance preparation for the article.

You are, of course, correct that the C.D. Howe Institute is a conservative organization and the sole purpose of this report was to derail the current retirement income debate in Canada into an attack on the Federal Public Service Pension Plans.

Unfortunately, this initiative has been somewhat successful. The C.D. Howe report was released on December 16th, 2009, the day before the Federal-Provincial Finance Ministers meeting in Whitehorse. Miraculously, the report became an agenda item at the meeting and the Provincial Finance Ministers seized the opportunity have Federal Finance Minister Flaherty commit to "addressing" the Federal Public Service Pension Plans as part and parcel of any pension reform package.

As you can see from a further article from Kathryn May in today's Ottawa Citizen, a showdown appears to be brewing between federal public service bargaining agents and the Federal Government over proposed cutbacks to the Federal Public Service Pension Plans. Today's appointment of Stockwell Day as President of the Treasury Board will only intensify the dispute.

Indeed, Prime Minister Harper did shuffle his cabinet on Tuesday, appointing Stockwell Day as President of the Treasury Board:

As Prime Minister Stephen Harper shuffles spots on his year-old cabinet, all eyes are being cast on Okanagan Coquihalla MP Stockwell Day.

Day moves from his international trade post to the Treasury Board where he is to play a critical role in leading the government’s effort to curb spending and hold off the growing deficit.

“As we prepare for the return of balanced budgets once the economy has recovered, it will be essential for government to live within its means,” said Harper in a statement.

“I am assigning this task to Minister Day, one of the most senior members of the cabinet and a former provincial treasurer who has distinguished himself in every portfolio he has held.”

Get ready for an all-out war on pensions. One piece of advice to Minister Day: get your hands on the report I wrote for the Treasury Board on the governance of the PS pension plan back in the summer of 2007. It's not just about cutting pension benefits, you need to significantly bolster the governance of these plans if you're going to deliver cost effective, well managed pensions over the long-run (feel free to contact me for a briefing on pension governance gone awry).

And to the unions, my advice is to be prepared to compromise on some issues. We are going through an era of fiscal deficits which will take an enormous toll on public finances. The private sector is reeling and you simply can't ignore what is going on outside the public sector. All over the world, governments are raising the retirement age and pension contributions, cutting benefits and raising taxes to meet ever growing demands of their public pension plans.

Canada will not escape this tsunami of pension reform. All stakeholders, including the government of Canada, unions and taxpayers, need to compromise to sustain the long-term health of federal public pension plans. All-out war will do nothing but further weaken them.

Monday, January 18, 2010

$58 Billion Debt Time Bomb?

Kathryn may of the Ottawa Citizen reports that federal PS pensions a $58B debt time bomb, think tank says:

OTTAWA — The federal government's bookkeeping of its pension promises for public servants is out of whack with the real costs, understating Canada's national debt by $58 billion, says a report by a leading think-tank.

A study by C.D. Howe Institute on the "fair-value" costs of the pension liabilities for Canada's public servants, military and RCMP concluded the government's estimates are so understated that most of the surpluses racked up over the past decade should have been deficits.

"Experience in steel, cars, telecoms and other mature industries has shown how understating the cost and volatility of defined benefit obligations can lead plans to run accumulated deficits larger than their sponsors can cover, leaving pensioners short and/or taxpayers picking

up the pieces," said the report. "We need to get a better handle on public-sector pensions before similar accidents happen on a more colossal scale."

To cover the real costs of federal pensions, C.D. Howe president Bill Robson, who co-authored the report, said public servants should be contributing 34 per cent of their pay to the plan every year -- and the RCMP and military would have to fork over 41 per cent of pay.

The big difference in costs lies in the way pension liabilities and assets are accounted for.

Robson said the way federal pensions are now accounted for is exposing taxpayers and public servants to "under-appreciated risks," he said.

Robson said he finds no fault with the chief actuary who reviews the pension accounts, or Auditor General Sheila Fraser, who audits the government's financial statements, because they are following the accepted accounting practices. But he argues the unravelling of other defined-benefit pension plans like Nortel and GM exposed the shortcomings of these practices.

Defined-benefit plans are supposed to have enough assets to back the promised retirement income, but they aren't always managed and accounted for that way.

The books typically "smooth" out the value of assets by using a combination of past and projected future prices. The liabilities are understated using discounted future payments that are unrealistic so pension obligations look smaller than they really are.

Instead, Robson said the government should use "fair-value" accounting, which uses current prices to value assets and liabilities as if a plan was being liquidated or wound-down.

"It's crazy to show promises on the books for less that it would cost to pay off that obligation," he said.

"Our quarrel is they are using these high investment returns and, we say, there is a better benchmark that more closely resembles what the pensions will cost."

For Canadians, the difference

between the assets and liabilities recorded in the pension accounts is part of the national debt.

And lowballing the government's pension obligations in turn means the national debt has been understated by $58 billion, said Robson. The government recorded liabilities of $140 billion last year compared to $198 billion using C.D. Howe's fair value calculations. That means the debt is $522 billion, not the $464 billion recorded in the public accounts.

Fair-value accounting for pensions also turns the surpluses between 2002 and 2008 into deficits -- with last year's $7 billion higher than recorded.

The implications are huge, calling into question policy decisions made when the government thought it was racking up annual surpluses. The government went on a spending and hiring spree over the past decade, dropped the GST rate and cut corporate taxes.

The Conservatives are now racing to balance the books at a time when many say a demographic crunch has left Canada's economic potential at its lowest ebb in 40 years.

Pensions hit the national agenda with the collapse of Nortel and GM as angry workers and pensioners found pension funds didn't have the money to pay the pensions they were promised.

Not surprisingly, many pointed to the gap between the private and public sectors, which typically offer generous early retirement provisions and pension payments indexed to inflation.

The gulf between public- and private-sector pensions is an issue Finance Minister Jim Flaherty acknowledged he has to deal with in his pension reforms.

Federal unions believe the C.D. Howe study, which appeared as Flaherty met with his provincial counterparts in Whitehorse to discuss pension reform, put federal pensions on the table as the government struggles to find ways to reduce costs.

The private sector is abandoning defined benefit plans in increasing numbers for cheaper or more "financially sustainable" defined contribution plans.

In fact, the C.D. Howe report suggests the true cost of the plans could lead the government, like other employers, to convert its defined benefit plans to less volatile defined-contribution plans -- a proposal that would spark an all-out war with unions.

But Robson argues the unions should be pressing for change because it's their members who will be on the hook if the government doesn't fund the pension plans properly.

"Unions should also be concerned that the plan is largely unfunded. If they are looking out for the interest of their members, they should get more in this plan, so whatever happens to federal finances, that there are assets to back those obligations," he said.

Robson said the government has several options to "level the playing field" between the sectors. It could reduce the value of public servants' benefits or allow Canadians to build pension funds as big as public servants by allowing them to sock more than 18 per cent of their incomes into RRSPs.

"If a pension this rich is desirable for everyone and not just public servants, then shouldn't we be allowed to save more than we are now?" said Robson.

The government could better fund the plan by increasing the contribution rates employees pay into their plans. Contributions to pension plans are shared 50-50 between public servants and the province in Ontario, Quebec and Alberta so many argue there's no reason federal workers can't fully pay their way.

Now, it should be noted that the C.D. Institute is a conservative think tank which often takes positions based on conservative political views. They have argued for a private sector solution to the pension crisis, which I strongly disagree with.

But on the issue of underestimating pension liabilities, they raise important points. This study is likely overestimating liabilities because taking everything at market price is simply ridiculous given that private market assets (real estate, private equity, infrastructure assets) tend to be overvalued or undervalued at extremes.

One can make the case (albeit a small one) that these private assets are now undervalued. The problem is that they can stay undervalued for a lot longer than investors think. And if we enter a deflationary environment - something which Hoisington has brilliantly analyzed in their latest quarterly commentary, Hard Road Ahead - then it's going to be a long, tough slug for private markets.

Finally, I already discussed Mercer's little Alaska problem and the fact that according to some think tanks, like the British-North American Committee, governments of the US, UK and Canada are understating the true cost of public pensions. If true, then you got the seeds to the next debt time bomb. The hard road ahead is looking harder when you sit back and analyze the implications of all these pension liabilities, especially if you consider the possibility that they're grossly understated (read this Business Week article).