Wednesday, January 30, 2013

Caisse to Focus on ‘Less Liquid’ Assets?

Frederic Tomesco and Doug Alexander of Bloomberg report, Caisse to Focus on ‘Less Liquid’ Assets, CEO Sabia Says:
Caisse de Depot et Placement du Quebec, Canada’s second-largest pension-fund manager, will increase investments in assets such as real estate, infrastructure and private equity to reduce volatility in its returns, Chief Executive Officer Michael Sabia said.

“The markets are no longer a good gauge of value,” Sabia told reporters today during a briefing in Montreal. “Markets are a source of volatility. We think this volatility will last quite some time.”

The Caisse plans to add C$10 billion ($9.97 billion) to C$12 billion in what it calls less-liquid investments in the next two years, Sabia, 59, said. The Montreal-based fund manager seeks to have about 30 percent of its assets in private equity, real estate and infrastructure by the end of 2014, up from 25 percent.

“We have to find a replacement for the performance in fixed-income that will no longer be there,” Sabia said. “We want to stabilize the performance of the organization.”

The Caisse oversees pensions for retirees in the French- speaking province of Quebec, with a dual mandate to maximize returns and foster economic growth in the province. It had net assets of C$165.7 billion as of June 30, including about 37 percent each invested in publicly traded stocks and fixed income.

“Our objective is not to be spectacular,” said Sabia, who has been running the Caisse since 2009. “We are a long-term investor and what matters is the performance over three, five or 10 years.”
Alternative Assets

Canada’s pension funds have been looking to invest more in alternative assets such as infrastructure and real estate, said Scott MacDonald, head of pensions, insurance and sovereign- wealth strategy for RBC Investor Services. (RY)

“Elite-sized plans in Canada have been investing a disproportionate amount of their assets in real estate and infrastructure,” MacDonald said in an interview. “Those returns have been very high and that trend towards investing in those asset classes will continue.”

The country’s defined benefit pensions returned a median 9.4 percent in 2012, according to a survey by RBC Investor Services, a unit of Royal Bank of Canada.
Global Leaders

The Caisse also wants to build up a fund it started in January to buy stakes in companies it considers global leaders. It will add its holdings in Nestle SA (NESN), HJ Heinz Co. (HNZ) and Qualcomm Inc. (QCOM) into the fund, said Roland Lescure, chief investment officer, also speaking at today’s event.

The fund, which will account for about 10 percent of the fund manager’s assets, will hold onto its investments for the long term, he said.

The shift will come as the Caisse pares investments in traditional index investing. “In two to three years we will have fewer traditional equity investments,” Lescure said.

The Caisse plans to also increase investments in emerging markets, Lescure said. Emerging economies such as India and Brazil accounted for 5 percent of total assets at the end of 2011, according to the Caisse’s most recent annual report.

About C$41.2 billion of the Caisse’s assets are located in Quebec, according to the pension-fund manager’s 2011 annual report. The Caisse has invested in more than 530 Quebec companies.
SNC-Lavalin

Sabia said the Caisse plans to stand behind its investment in SNC-Lavalin Group Inc. (SNC), the Montreal-based company embroiled in corruption and fraud probes in Canada and abroad.

“SNC-Lavalin is tarnished because of what happened, but it’s a company worth building,” Sabia said. “They face some challenges but we will be there because we’re convinced of the potential.”

Canada’s largest engineering and construction company has been grappling with $56 million in incorrectly booked expenses and a former executive’s arrest in Switzerland amid a probe of corruption in North Africa. Former chief executive officer Pierre Duhaime faces fraud charges related to a Quebec hospital contract.

“This is a time when a long-term investor like the Caisse needs to help the company build a bridge to a different future,” Sabia said. “If we weren’t convinced of that we would have already exited.”

Canada Pension Plan Investment Board is the country’s biggest public pension manager, with net assets of C$170.1 billion as of Sept. 30.
I read this article last night and fired off an email to Michael Sabia: "Congratulations. You're now converted to a full-fledged pension fund manager! -;)" and added "Be careful with alternatives, they're no panacea." He replied "Thanks!!".

Of course, I was kidding around about being converted to a full-fledged pension fund manager, but dead serious about alternatives not being a panacea. These days it seems like all pensions are betting big with private equity, real estate and infrastructure.

And remember, whenever the pension herd moves into any asset class in such size, its collective action impacts the risk premium in this asset class, bringing down future returns.

But Michael Sabia thinks the bond party is over and he's right, faced with historic low bond yields and volatile equity markets, more and more pensions are looking at illiquid asset classes to achieve their actuarial rate of return. Let me sum up the reasons why pensions are taking this route into illiquid asset classes:
  1. Volatile public markets: Historic low bond yields, sovereign bond concerns, volatile equity markets, massive quantitative easing by central banks, high-frequency trading, naked short-selling, hedge fund Darwinism and cannibalism. Even the world's biggest and best hedge fund is having trouble posting the returns it once did and other well known quant funds are chopping fees in half to stay competitive. In such an environment, how are large pension funds suppose to compete? One way is to take a long-term approach in both private and public markets. Also, illiquid investments aren't marked-to-market, so stale pricing due to infrequent valuations provides much needed return diversification for these large pensions.
  2. Stable cash flows, more control: Pensions like the stable cash flows that come with illiquid asset classes like real estate and infrastructure. It makes it easier for them to plan for liquidity needs of paying out pensions. Also, Canadian pensions do a lot of direct investments in private equity, and co-invest with top funds, giving them more control over these private investments.
  3. Leverage: Another reason pensions like illiquid asset classes is because they can use leverage to juice up their returns. Some pensions have internal limits on how much leverage they can use but this doesn't apply to their external private equity managers.
  4. Managing reputation risk:  Pension funds have become so scared facing their depositors every time they lose money that they're working hard to develop a framework to insulate themselves from negative press articles and manage reputation risk. Notice how the focus shifts on absolute returns when they underperform public market benchmarks. The problem is that many pensions, including the Caisse, are not taking enough risks in public markets. It's less risky to do so in private markets where they can play around with fair value and benchmarks.
  5. Much easier to fudge private market benchmarks: The fifth and equally important reason large Canadian pension funds love illiquid asset classes that it's easier to "fudge" these benchmarks, increasing the probability of beating their overall policy portfolio (beta) benchmark. This translates into big fat bonuses for senior managers at large Canadian pension funds. In other words, potential compensation influences their behavior and choice of asset classes. Without fail, if you take any annual report of all these large funds since the crisis, you'll see their president stating "significant value added was achieved in real estate, private equity and infrastructure." Duh! Because in most cases, private market benchmarks don't reflect the risks they're taking in these illiquid asset classes (ie. do not take into account illiquidity, leverage, and beta of the asset class).
On the issue of benchmarks in illiquid asset classes, in my last comment on pensions betting big with private equity, I wrote that even though it isn't perfect, I prefer using a spread over public markets to gauge the value added of these private investments. An astute investor in private equity sent me this comment:
Public benchmarks make no sense for private equity, and create huge perverse incentives. Might work when one looks back over ten years, but there is no actionable perspective that a public benchmark provides over any useful timetable. I can tell you many dysfunctions of public benchmarks, the whole fund secondaries businesses with discounts to NAV creates huge incentive to transact in this fashion as an obvious example.
And if private equity is supposed to be a diversifier, then in any give year why would aligning with public markets be expected? You will end up paying people for expected diversification effects. If it was so darn simple, do private equity and beat the public markets, and get diversification, holy grail!
Funny how it doesn't work out that way. CPPIB, net of costs and currencies has LOST money on private equity. Someday this will become a major problem for them. And OTPP doubled down with huge commitments at peak cycle too. Their returns on private equity are fading with time, and will not beat public markets long term. Inconvenient truths...too bad allocations continue to be made on the basis of "facts" that don't hold up to due diligence.
He also shared this with me:
I think the strategy around illiquids is very superficial, and the risk of actually owning a company, rather just some shares, carries immensely more responsibilities and the skills and wisdom is beyond that of a "portfolio manager" with numerous other investments to attend to.. Few organizations have really been tested as owners, the institutional business model just does not lend itself to long term accountability landing on a specific individual.
Whoa! Talk about exposing the bullshit in private equity! Before I get bombarded with emails from CPPIB and Ontario Teachers' telling me these assertions are wrong, would like to highlight many other large funds, including CalPERS and PSP, made huge commitments at peak cycle too. Funds learned the hard way all about vintage year diversification. This is what allowed the secondary market to flourish after the crisis.

I still believe that private equity is inextricably tied to public equities. The same can be said about real estate and infrastructure. It's obviously not the same as there should always be opportunities to exploit in these private markets that are not as readily available in public markets But at the end of the day, the opportunity cost of investing in private should be some spread over public markets. The perverse incentives this may create, however, must be taken into account by board of directors.

Finally, while I understand why the Caissse and others are betting big with private, illiquid asset classes, I question the timing as they risk missing the Mother-of-all bull markets. Also worry about them underestimating the risks of these investments. I don't think private markets are the panacea pension fund managers make them out to be and there have been some huge losses and mishaps in these assets too at the Caisse and other large pension funds (need I remind you of the Holy Halabi incident?).

Also, I think the Caisse and other large pension funds can do a hell of a lot more to bolster their internal public market and absolute return groups which focus on taking timely, opportunistic risks in public markets.

The focus on large, global companies is fine but there is a lot more juice to exploit in the small and mid cap space. Even in large global companies, there are tremendous opportunities in companies that are undervalued (eg. Nokia!). As far as emerging markets, can play them directly or through American companies like Caterpillar or through sectors like coal, copper and steel. In my opinion, the Caisse did a huge mistake in indexing their global equities after the crisis.

Another wise investor and former pension fund manager shared these excellent insights with me after reading this comment:
Excellent article. I am always impressed to see that some investors still think that illiquid assets are less volatile. Most investors know that illiquid assets have their traditional risk measures (standard deviation, covariance, correlation and beta) underestimated due to stale pricing and infrequent “third-party” valuations. Of course, one can use relatively simple statistical adjustments to estimate the true underlying risk but many investors still prefer to stick with the underestimated risk measures.

Private equities generally use more leverage than the average public market investment. It is therefore not surprising to observe a statistically adjusted Beta higher than one. A leading edge Canadian investment organization assumes an average beta of 1.3 for its Private Equity portfolio.

If you don’t risk-adjust your returns, investing in levered strategies, high beta strategies, and private equities may look like a winning strategy. This will outperform when the public market goes up, and it will underperform in down markets. In the long run, assuming the markets go up, the strategy will work but with much more real volatility than its benchmark.

I have done some statistical analysis of a large investment organization using such approach and conclude that its departure from its benchmark in investing into levered strategies, high beta strategies, and private equities is statistically significant. I also find that its residual alpha is significant too but negative. Thus, if one has a negative investment skill (in the sense of stock picking, bond picking, etc), one can try to hide it by leveraging its Beta…

At the end of 2011, the Caisse’s benchmark had 24.4% exposure to private equity, infrastructure and Real Estate. The actual portfolio was slightly overexposed at 25.0% (down from 25.4% in 2010). The planned increases from 25% to 30% will significantly increase the active risk of the portfolio. The unadjusted (apparent) total risk may go down but the true (adjusted) total risk will significantly go up. The Caisse with the largest risk department in Canada (and one of the largest in the world) should know better.

As you mentioned, benchmarking is a major issue in private equities. And one should always be skeptical of changes in those benchmarks. Many such benchmarks are non-public and many suffer from survivorship bias. I have observed one major investor outperforming its benchmark by more than 20% in the first half of the year, then matching its new benchmark in the second half. Was the benchmark changed to lock-in an outperformance obtained by improper risk taking?

I also agree with your observation that the herd behavior of investors out of public equities, into private equities is changing the supply/demand relationship of these assets and therefore affecting their future return potential – something to keep in mind. If too many investors are chasing the same private equity deals, the higher pricing of these investments can only make future returns lower.
Finally, while we're on the subject of illiquid asset classes, maybe the Caisse should invest in Quebec's grossly dilapidated infrastructure. Montreal is recovering from major flooding after a water main broke near the intersection of Doctor Penfield Avenue and McTavish Street, sending water gushing into the downtown core. Below, CBC's Joanne Vrakas reports on cleaning up this mess.