Nicolas Van Praet of the National Post reports, ‘Leverage is financial steroids’:It’s become a fact of life in Quebec that if you’re the coach of the Montreal Canadiens or the chief executive of the Caisse de dépôt et placement du Québec, there’s always somebody, somewhere out there screaming for you to resign.
In Michael Sabia’s case, it happened even before he set foot in his 11th-floor corner office suite.
As the first anglophone and non-Quebecer to lead the Caisse, Canada’s largest pension fund manager, Mr. Sabia was the subject of attacks from the moment he was named to the job in March 2009. His employment track record? “Controversial at best,” wrote one columnist. His connection to Jean Charest by way of Brian Mulroney and the Privy Council? Proof of political favouritism, wrote another.
The critics were merciless. He’s an outsider from Ontario, they charged. He could never succeed in steering the Caisse in its historical role fostering a Quebec French-speaking financial class. He’s a crony, they said. Not the right person needed to plant the Caisse back on course and claw back the embarassing $39.8-billion annual loss under his predecessor in 2008 — the biggest in Canadian pension-fund history.
Funny how time can change perceptions. Funny, too, how the bottom line tends to speak for itself.
When Mr. Sabia took over from former CEO Henri-Paul Rousseau, the Caisse had $120.1-billion in net assets as of the end of 2008. Since then, the fund has grown that asset base by $37.8-billion through the end of June 2011, to $157.9-billion. Its two-year annualized return is 14%.
If the pension fund’s private investments sufficiently offset likely stock market losses, it could tally a third straight year of positive returns when it reports 2011 results as scheduled at the end of February. That would put it within striking distance of recouping the money lost under Mr. Rousseau.
Those who know Mr. Sabia will tell you he will not be taking sole credit for the recovery, when it happens. That’s just not his style. He’s not a flashy guy. He doesn’t like fancy restaurants. He doesn’t fuss with expensive suits or watches. Prone to self-deprication, the bilingual 58-year-old is not a fan of hyperbole or dramatic language.
In an interview last week at Caisse headquarters on the edge of Montreal’s old quarter, he wore a casual red wool sweater. No tie. In many ways, he’s Quebec’s Sergio Marchionne, an expert in industrials who talks straight, dresses down when he can, and thinks three steps ahead.
Besides, as Mr. Sabia well knows, the real test is yet to come: How to protect depositors’ money more permanently against the kind of volatility currently lashing the world economy. And how to more definitively restore public confidence in the Caisse, shredded after a spectacular failure of risk-management that showed it simply didn’t understand many of the investments it was making.
“When I got here … the place really felt under siege and there were lots of morale issues,” Mr. Sabia says. “The thing that has mattered a lot is getting people to feel like the organization is moving forward, that is has a direction, that they’re part of something that’s progressing. And I think that’s happening.”
Make no mistake, this is not the same Caisse that saw one quarter of its assets wiped out in 2008. Its 13-member executive committee has been almost completely shaken up. New executive talent has been tapped including Roland Lescure, an investment specialist from France who led one of that country’s largest asset management firms. As well, risk-control practices have been dramatically tightened.
That work done, Mr. Sabia is focussing on the next phase in the Caisse’s development, one that’s arguably a lot tougher.
The former Bell Canada chief executive is now trying to build an organization in which all of its investment professionals have a profound understanding of what the Caisse has bought and why, a knowledge of investments that goes beyond profit and loss statements and digs into the quality of operations. He’s already got real-estate professionals who run shopping malls and office towers. Now he’s begun hiring specialists who know airports and pipelines and mines.
It’s all part of a rethink of the pension fund’s diversification strategy — one that will see it shift away from buying indexed stocks towards fewer but more targetted investments that are much better mastered, and from both public to private markets.
“You’re going to see people moving away from the extent of the reliance that we’ve all had on public markets,” Mr. Sabia says. “There are probably better returns” privately, he added, and they’ll be more stable over time.
Pulling back from public markets will create some accountability challenges for the Caisse because its performance is measured against that of various public benchmarks such as the S&P/TSX composite index and the S&P 500. It will have to figure out different ways to communicate successes and failures and what exactly it is doing. That may be difficult given the trust between the fund and its 25 Quebec depositors remains on the mend.
“The confidence of retirees in the Caisse is still shaky,” says Madelaine Michaud, president of the Association québécoise des retraité(e)s des secteurs public et parapublic, a group representing 27,000 retired workers, most of them civil servants. She says the Caisse has been unresponsive to its demand that it allow a retiree representative on its board.
Underpinning Mr. Sabia’s transformation of the Caisse is the belief that it should use leverage in a much more limited way.
In this, he is certainly not alone. Many companies, notably Magna International Inc. under Frank Stronach, have displayed a nearly religious aversion to carrying debt. The Caisse itself has reduced its liabilities by half during the past five years, to 17% of total assets in 2010 from 30% in 2004.
If the financial crisis of 2007-2008 taught the world one thing, it’s that borrowing big is bad. As the U.S. government commission analyzing the debacle concluded: The crisis was avoidable and was caused in part by widespread failures in financial regulation, dramatic breakdowns in corporate governance including too many financial firms acting recklessly and taking on too much risk, and an explosive mix of excessive borrowing and risk by households and Wall Street.
Where Mr. Sabia differs from others on debt is in his willingness to pass up investments using leverage because of the chance it will come back later and bite. To him, buying an investment that generates small and consistent profits with no debt is better than using debt to buy something that may result in big profit-loss swings.
“Look, leverage is just a financial steroid. That’s all it is,” he says. “[And] in a volatile world, you don’t want to be on steroids.”
Michel Nadeau, a former Caisse vice-president, agrees. “The Caisse abused its use of leverage in the past,” he says. “Way too much.”
There are conflicts in that dogmatic position.
If leverage is so bad, why is the Maple Group, that consortium of 13 institutions including the Caisse, using it in spades to buy the TMX Group? And won’t the steroid actually turn into a straightjacket — immobilizing the Caisse at the very time it is convinced there are massive buying opportunities out there because of depressed asset valuations and desperate governments?
To be sure, the Caisse has plenty of cash to play with. But its appetite for asset purchases sounds bigger than what those cash stores may hold.
Mr. Sabia says there will be a wave of substantial infrastructure privatizations in Europe in the months ahead as governments deal with their fiscal issues. The Caisse is a buyer in that scenario, likely in club deals with other investors. Like the Ontario Teachers Pension Plan and others, it has become a potential saviour for states that can sell instead of slashing social programs and risk undermining economic growth in their bid for budgetary sanity.
“If I were in a European government, I would be way more interested in trying to sell a port, sell a toll road, sell a bridge, sell a whatever than I would be … to constantly cut social expenditures,” he says. “There are limits to the political tolerance for those things.”
Likewise, the Caisse is very bullish on the United States. It is watching for motivated sellers of U.S. assets, particularly Europeans who may want to offload real estate. The Caisse has been bitten in this market recently — a Jan.11 Wall Street Journal report said it sold $111-million worth of debt it held on Manhattan’s Park Central Hotel at a loss. But there are plenty more deals to be had.
“The degree of motivation has been increasing recently,” Mr. Lescure says of the sellers. “We’re not a vulture. But what we’re looking at is good opportunities …. The prices are slowly but surely coming down.”
There are other plans on the table. The Caisse is underinvested in emerging markets and wants to increase that exposure. And it has people working on putting together infrastructure investment proposals to support the resource boom projected as part of Quebec’s $80-billion plan to develop its northern territories.
Companies pulling iron ore out of the ground to fuel production in China’s steel-making factories will need shelter for their employees, roads or railroads to get the resources out, and ports to ship it overseas. Funding for a couple of projects has been announced but the infrastructure needs vastly outweigh current supply.
Stoking economic development in Quebec is one of the Caisse’s mandates, something many observers consider a hindrance to the larger imperative of making profits for its depositors. And yet, there are many influential people who believe the Caisse still isn’t doing enough to fuel growth in the province.
It all amounts to a delicate political balancing act for Mr. Sabia, one made all the more complicated when the Caisse runs afoul of provincial language laws. Still, for all the pension manager’s missteps, it is difficult to imagine another Caisse CEO bearing down as hard to prove the naysayers wrong.
The Caisse is a machine whose overhaul is still in progress. It’s all about deepening the understanding of its investments. And Mr. Sabia has plenty more deepening to do.
“I have a pretty simple view of this, and maybe it is an outsider’s view,” Mr. Sabia concludes. “But the whole problem with the investment world is that it got way too preoccupied, way too convinced that as a sector it was the smartest guy in the room. Well, it didn’t turn out to be.”
The article covers many points so let me tackle them one by one. First, it is true that Sabia's appointment created quite a ruckus in Quebec. When his predecessor, Henri-Paul Rousseau, was appointed, the French media lauded him as some sort of 'financial God'. And when the $40 billion train wreck took place, they turned on him, viciously attacking him (Rousseau wasn't the only one to blame in that debacle).
It's easy to attack leaders, and in some cases they deserve it, but Quebec's media is particularly ruthless and shallow. Witness the recent language fiasco at the Caisse and how the French media totally ignored the real issue, namely, the public sector should reflect Quebec's diversity:
When the issue of linguistic or cultural diversity comes up in Quebec, it's rarely to show how diversity benefits the province's economy or helps its workforce become more open, tolerant and flexible. Too often, diversity in the workplace is seen instead as a threat to the primacy of French as the language of work. For weeks last year, the province was embroiled in the issue of whether the Caisse de dépôt should continue to employ two senior executives who did not speak French. The previous year's big Caisse issue - its largest ever loss of $39.8 billion - didn't seem to upset people nearly as much, or for as long.I will repeat, the Caisse, PSP Investments, the National Bank, Desjardins, Hydro Quebec and other financial institutions in Quebec need to do a hell of a lot more in improving the diversity of their workforce at all levels. This is especially crucial at a time when Quebec's unemployment rate is spiking up (it's not a 'statistical anomaly', it will get worse).
Back to Sabia. He has made several important changes to the Caisse to bolster governance making operations more transparent and managers more accountable but he and his team have a lot more work ahead of them, which they are well aware of.
The shift to private markets is basically what every other large public pension fund is doing in Canada. Why are they doing this? First, to escape the volatility in public markets but the other reason, one that they won't tell you about, it allows them to beat bogus benchmarks and collect big bonuses claiming they added value in private markets. Let me remind people, when it comes to pension investments, it's all about the benchmarks, stupid! And the third reason is leverage -- it allows them to use external managers who can lever up a lot more than they can do internally.
On the point of leverage, Sabia is right and wrong. For me, using leverage is like using derivatives. In the hands of a fool, it can wreak havoc and lead to huge losses. However, those who know how to use derivatives properly can mitigate risk, index properly and efficiently, and make money. Same for leverage. If you know how to use leverage wisely, you can add value to your operations.
Some pension funds use more leverage than others. It's well known that Ontario Teachers' uses a lot of leverage in their operations. But if they know how to use it properly, they can enhance risk-adjusted returns. Leverage is a double-edge sword. You can enhance returns but if you take foolish risks, you'll get burned.
On this last point, the Caisse needs to do a lot more work on taking risk, especially in public equities where they underperformed over the last few years. In my opinion, the Caisse focuses too much risk management and not enough on taking opportunistic risk. But to do this properly, they need to better leverage off their external managers and create a central research group similar to the one at CPPIB and even better.
In short, the Caisse needs to centralize investment research. I already mentioned that Roland Lescure is the CIO of public markets, not all investments at the Caisse. Some say this doesn't matter but if you ask me, the best pension funds have a dedicated CIO and a dedicated research team that looks at all asset classes, focusing on allocating risk across public and private markets. This way you break down silos and leverage information from all sources to make critical decisions, including asset allocation decisions which determine overall returns.
Finally, the Caisse needs to hire more investment professionals and less administrative and support staff. I'm concerned about the lack of jobs in Montreal's investment community and think the Caisse and others, like PSP Investments, need to do a lot more hiring of investment professionals and a lot more to support and seed investment funds in this city.
And they can start by helping me out, the world's best and most underpaid pension analyst. I'm being facetious but the truth is any pension fund would be lucky to have a guy like me on their team. Nobody can cover pensions and markets the way I do, nobody. When I'm on my game, working with good people (not weasels), I thrive and deliver results. Just ask the president of a major pension fund in this city who once told me: "You're the best investment analyst I've ever worked with". At least he got that right!
Below, James Gorman, chairman and chief executive officer of Morgan Stanley, talks about global market conditions, the European sovereign-debt crisis and financial regulation. Gorman, speaking with Bloomberg's Erik Schatzker at the World Economic Forum's annual meeting in Davos, Switzerland, also discusses Morgan Stanley's compensation measures. Tell them to stop whining, they're lucky to have a job and still grossly overpaid.
