Tuesday, April 6, 2010

Ontario Teachers' Confounding Year?

Phred Dvorvak of the WSJ reports, Canada's Big Teacher-Pension Fund Has 'Confounding' Year:
Ontario Teachers' Pension Plan, which manages the assets of one of Canada's biggest pension funds, said it had a strong year in 2009, with the value of its assets rising to C$96.4 billion (US$96.3 billion), and a return of 13%—more than four percentage points over its benchmarked return.

Yet little of that gain came from the direct investments in private companies, infrastructure projects or real estate that Teachers' is famous for, and increasingly relies on to help boost returns. In 2009, those types of assets generally performed worse than their market benchmarks, Teachers' said in its annual results report, released Tuesday.

What's more, Teachers' said plummeting interest rates made it harder to meet its future obligations, sending unfunded liabilities soaring to C$17.1 billion—almost seven times what it had been the year before.

It was a "confounding" year, even though Teachers' "made back a great deal of what we lost in 2008," said Chief Executive Jim Leech.

Teachers' mixed results underscore the challenges facing pension funds. Fund executives say investment in stocks and bonds won't be enough to cover pension liabilities in years to come. Putting money in other kinds of assets that aim to beat indexes such as private-equity funds is risky, and doing so through outside advisers can be costly.

So during the past two decades, Teachers' and other big Canadian pension funds have sought to remake themselves into savvy international investors that increasingly rub elbows with the likes of Kohlberg Kravis Roberts & Co., Bain Capital and Carlyle Group as they search for ways to boost returns. They're staffed by people with experience in investment banking and private equity, and run by executives who often are paid more than their peers in the U.S.

Mr. Leech, a former banker, got C$2.3 million in salary, bonus and incentives last year; the California Public Employees' Retirement System, the U.S.'s largest public pension fund with more than twice the amount of assets Teachers' has, paid its CEO and interim CEO—each of whom worked for about six months—a combined $509,812 in salary and bonus in the year ended June 2009.

Teachers' boasts that its private-equity group, which employs 55 people and had C$10 billion in investments at the end of 2009, is one of the biggest such pools of capital in the world.

The group runs so much like a private-equity fund—with inscribed plaques on a wall to commemorate deals and members who call themselves "partners"—that one of its biggest worries is that real private-equity funds will steal talent, said Erol Uzumeri, the group's head.

Teachers' 20-person infrastructure team manages all of its C$7.9 billion in investments in assets like airports and toll roads internally.

This year, Teachers' has announced four new acquisitions in which it was a lead investor, including the purchase for an undisclosed sum of aluminum-container maker Exal Group, with $400 million in annual revenue, and an agreement to buy the operator of the U.K. lottery for half a billion dollars.

The Canada Pension Plan Investment Board, which manages C$123.9 billion in assets for Canada's national pension fund, last year beat out all the big private-equity and sovereign-wealth funds in terms of deal volume, with 12 announced deals totaling $23 billion in which it was a participant, according to data tracker Dealogic.

But as recent performance shows, the active-investing style doesn't always deliver consistently over the short term. Teachers' and the Canada Pension Plan both lost around 18% in asset value during the years ended December 2008 and March 2009 respectively, their worst performances ever. Calpers saw a 24.8% decrease in the value of its assets in the year ended June 2009.

In 2009, Teachers' infrastructure holdings were pummeled by lower earnings in industries like utilities and a fall-off in shipping. The Teachers' private-equity portfolio was hurt by valuation losses and the depreciation of the U.S. dollar, which made many of its non-Canadian assets worth less in Canadian currency. The group closed no transactions last year.

Still, the funds say their tactics are paying off long term. Teachers' says its return over the 19 years of its existence has been an average annual 9.7%, C$19.2 billion above what it estimates equivalent market returns would have been. U.S. pension funds had a median annualized return of 8.25% over the same period, according to fund database Wilshire Trust Universe Comparison Service. Private-equity assets didn't do well last year, but four-year returns were around 2.5 percentage points over their benchmarks—better than the performance of other asset classes.

At the Canada Pension Plan, CEO David Denison said the fund's long horizon and stable pool of assets means it can keep investing even as lack of cash and unattractive short-term returns have sidelined other investors.

Tough financial and economic conditions allow the fund "to be even more competitive in seeking out investment opportunities than a more benign environment, because then anyone can take advantage of it," said Mr. Denison.

I like the part which states that Teachers' private-equity group is worried that real private-equity funds are going to steal talent away from them. More nonsense to justify their bloated compensation.

Moreover, Bloomberg reports that LBO Capital Raising Plummets 81% From Peak in 2008:

Carlyle Group, the world’s second- largest buyout firm, needs more time to raise $3 billion. So does Chicago-based Madison Dearborn Partners LLC, even after cutting its target by 25 percent to $7.5 billion.

Private-equity firms, more reliant than in the past on management fees to offset lower profits from selling or taking companies public, saw quarterly fundraising decline 81 percent from the peak in 2008, according to London-based research firm Preqin Ltd., forcing them to extend deadlines and scale back the amounts they seek from investors.

It’s taking almost four times longer to cement commitments for funds of more than $1 billion than it did in 2004, Preqin data show. At the same time, investors are getting stingier and more discriminating. Buyout funds of all sizes raised $13 billion in the first quarter, the least since the fourth quarter of 2004, the firm said. At the peak of fundraising in the first quarter of 2008, they took in $68 billion.

In this environment, I wouldn't worry too much about private-equity funds stealing "talent" away from any big Canadian public pension fund (Why bite the hand that feeds you, even if they're scaling back? Besides, PE funds are firing their own talented people.).

Back to Teachers' 2009 results. I read the press release on Teachers' website as well as the 2009 Report to Members. A copy of the full 2009 Annual Report is available along with a commentary and financial statements. You can find additional info by clicking here.

In the 2009 Annual Report, there is an excellent discussion on the Plan's funding status which begins on page 10. Karen Mazurkewich of the National Post reports that Teachers faces serious funding challenges:

Ontario Teachers’ Pension Plan still faces a Sisyphean task managing its pension obligations for the 289,000 active and retired teachers in the province. Although the plan’s investors scored a 13% annual rate of return in 2009, the fund is recording a $17.1-billion deficit -- more than five times larger than the previous year.

OTPP recouped a “fair amount” of the money lost in 2008, when the plan announced a negative 18% in investment returns, said Jim Leech, president and chief executive of the plan. “But we continue to face serious funding challenges.”

With only 1.5 teachers for every retiree, the fund’s future pay-outs are now greater than projected assets. But the lack of working teachers is not the main culprit creating this gap: the drop of real interest rates from 2.1% to 1.5% widened the deficit hole by $15-billion.

While the deficit is not going to have an immediate impact on teachers, Mr. Leech said “the sponsors are looking at some minor course corrections that can have an impact over time.”

An action plan based on consultations between OTPP, the Ontario Teachers’ Federation and the government, will be released later this year, although any recommendations will probably not be implemented until 2012.

Last year, the fund made $10.9-billion dollars raising its assets-under-management to $93.5-billion. The tidal rise was in a large part due to the 21.4% rate of return the in its overall equities envelope. OTPP can thank a significant chunk of its overseas returns to Eike Batista, the controversial and charismatic Brazilian entrepreneur behind the Brazilian OGX Petroleo and LLX Logistica. Several years ago, OTPP made significant investments in Mr. Batista’s companies and is now reaping the benefits.

Canadian equities returned 23.5% but under performed its benchmark, primarily because its private-equity arm had a negative 2.8% return compared to a benchmark of 11.3%. Although private-equity did not suffer any collapses within its portfolio of companies last year, the negative mark-to-market valuations they experienced underscores the beating this sector, as a whole, has suffered. OTPP’s infrastructure holdings were also hard hit, recording a negative 5.5% return thanks to the rise in the Canadian dollar, said Neil Petroff, executive vice-president of investments and chief investment officer.

After “refocusing” its fixed income portfolio, and bringing its hedge fund management in-house, OTPP recorded a historic 23.4% rate-of-return this year in this envelope. “We made money in credit, hedge funds and in absolute return strategies,” said Mr. Petroff.

One of the major tweaks to the overall pension fund was the creation of a long-term equities desk within its public equities portfolio. Last month, Lee Sienna, vice-president of long-term equities, made his first investment. The group acquired the Camelot Group, which holds an exclusive licence to operate the U.K. National Lottery, for an estimated $590-million.

“Our new strategy is to find stable companies with high-barriers to entry that we can hold for many many years,” says Mr. Sienna. The average mutual fund turns over its entire portfolio every year, and OTPP’s regular public equities group flips about 20-30% of its stock annually, but this new area -- which will grow to more than $1-billion -- is expected to have a turnover rate of less than 10% annually. By creating this desk, OTPP hopes to build expertise, save on transaction costs, and reduce investment risks, says Wayne Kozun, senior vice-president of public equities.

This new area makes perfect sense for a public pension fund, and Wayne Kozun is a smart guy who knows what he's doing. Much of the outperformance came from global equities (page 38):

Non-Canadian equities (both public and private) totalled $32.8 billion at year-end compared to $28.7 billion at December 31, 2008. They returned 21.2% compared to a benchmark return of 13.6%, or $1.8 billion above the benchmark. The main drivers of outperformance were active management decisions to invest in two Brazilian companies – OGX Petróleo and LLX Logistica. These companies, which performed very strongly against market benchmarks, are held in the Relationship Investing portfolio. Externally managed portfolios also contributed to above-benchmark performance. We measure performance in Canadian dollars, which dampened non-Canadianequities returns as the Canadian dollar rose against most foreign currencies.

Another sharp cookie at OTPP is Ron Mock, one of the most impressive pension fund managers I've ever met. For many years Ron was running the external hedge fund portfolio, investing several billions into a multi-strategy hedge funds, funds of funds and single strategy funds that deliver true alpha. He is still running external hedge funds but Ron is now Senior VP, Fixed Income and Alternative Investments.

I can still remember our first meeting when he kept repeating the following point:

"Beta is cheap. You can swap into any index and get market returns at low cost. True alpha is worth paying for. I am looking to allocate to several managers who can consistently deliver T-bills + 500 basis points with zero correlation to stocks and bonds."

Of course, that's easier said than done, and after 2008, the landscape for hedge funds radically changed. "The old model of charging 2 & 20 for beta is dead," Ron told me during my last visit at Teachers. Unfortunately, he underestimated the stupidity of the pension herd as global hedge fund assets are on track to return to the pre-financial crisis peak of almost $2 trillion by year-end (at least institutional investors are fighting back against forced lock-ups on their hedge fund investments).

If you click on the image above, you'll see that Fixed Income delivered 23.6% in 2009, trouncing the benchmark return of -4.6%. This is very impressive, especially since they scaled back considerably on internal and external hedge fund strategies. This outperformance in fixed income undoubtedly came from being long spread products (ie., mostly beta).

I went to page 36 of the 2009 Annual Report to see what benchmarks were being used for each asset class:

(click on image to enlarge)

I am a little confused on the Fixed Income benchmark since bonds did well last year. According to Brockhouse Cooper's Q4 report, the Dex Universe Bond Index up 5.4% in 2009 and global corporate bonds did exceptionally well in 2009.

The only point I am making here - one that I've mentioned before - is that whenever senior pension fund managers trounce their benchmark by such a wide margin, it's typically because the benchmark does not accurately reflect the risks of the underlying investments.

This works both ways. For example, on page 38 of the 2009 Annual Report I note the following:

Private equity investments (included in the above totals for Canadian and non-Canadian equities) totalled $10.0 billion at year end compared to $9.9 billion at December 31, 2008. Teachers’ Private Capital returned -2.8% compared to a benchmark return of 11.3%, or $1.4 billion below the benchmark.
And the benchmark for real estate (CPI + 500 basis points) is a joke, especially if you consider that real estate's outperformance came from public real estate holdings (page 39):

The real estate portfolio totalled $17.2 billion at year end compared to $16.2 billion at December 31, 2008. The portfolio returned 7.0% compared to a benchmark return of 6.0%, or $0.2 billion above the benchmark. On a four-year basis, these assets generated an 8.3% compound annual return, outperforming this category’s four year benchmark by 1.6 percentage points.

Rising equity markets increased the value of our publicly listed real estate holdings in 2009, primarily Multiplan Empreendimentos Imobiliários in Brazil and Hammerson plc in the U.K., which contributed significantly to above benchmark performance for real estate.

This performance was partially offset by valuation losses in our North American property portfolio, reflecting the recessionary impact in certain North American property markets.

I don't want to get into the nitty gritty details of proper benchmarking, but I can show you ways to game benchmarks in alternative investments (private equity, real estate, infrastructure and hedge funds) that will make your head spin.

All in all, Teachers bounced back in 2009 and they too enjoyed the beta boost that so many other funds enjoyed following the disaster of 2008. Teachers' CEO, Jim Leech, cautioned that much of the market rebound last year was the result of a return of confidence in the financial markets and not of true economic growth:
“We should not expect this kind of market growth going forward,” he warned. “In 2008 and continuing into the first quarter of 2009 we saw a crisis of confidence among investors. It caused market mayhem. After the markets bottomed out in March 2009, confidence edged back up and with that came a return to more reasonable valuations. We expect it will still be some time until true economic growth takes hold.”

This means that Mr. Leech and his investment team led by Neil Petroff, Teachers' Executive Vice-President, Investments and Chief Investment Officer, have their work cut out for them in the years ahead.

But no matter how good they are, they can't deliver the returns to get the Plan out of its pension deficit, a point that Mr. Leech made at the press conference:

“Let’s put it this way: 2009 was a lot better than 2008, and better results,” Jim Leech, chief executive officer of Ontario Teachers’, said today in a briefing with reporters in Toronto. “We’ve got this funny thing going on this year: great investment results, yet our deficit continued to go up.”

Ontario Teachers’ said its estimated funding shortfall jumped almost sevenfold from last year’s initial projection to C$17.1 billion, with about C$15 billion of the deficit resulting from historically low interest rates. Investment gains were less than the average 16 percent return for Canadian pension funds, as estimated in a January report by a unit of RBC Dexia.

“We’re obviously very sensitive to the real interest rates and our investment program endeavors to address that,” said Leech, 62. “But it would be imprudent to believe that investment results alone can close that gap.”

Teachers' would need a substantial rise in real rates and solid investment gains to curb the deficit, and even that won't be enough, which is why they're exploring other options with their plan sponsors.

I also recommend that plan sponsors conduct a thorough, independent performance audit of all investment activities, and make sure benchmarks accurately reflect the risk being taken. Importantly, you want to make sure you're paying senior pension fund managers for true alpha, not leveraged beta. Nothing confounding about that.

***Executive Compensation***

Several asked me about executive compensation, so here you go (from page 65):

(Click on image to enlarge)

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